Why US Tax Reform Will Put Even More Pressure On Dollar Funding Markets

On Wednesday, we noted the renewed tightness developing in dollar funding markets. Ignoring embryonic signs of stress in the financial “plumbing” can be dangerous. The divergence of LIBOR from Fed Funds on 9 August 2007, which occurred two months prior to the peak in the Dow, always comes to mind. Fast-forwarding to the present when Mark Cabana, Bank of America’s head of US STIR, has been fielding client questions about the impact of proposed US tax reform.

In particular, clients asked for Cabana’s view on what effect dollar repatriation by US corporates might have on funding markets if favorable tax treatment is forthcoming.  

Spoiler alert – negative for dollar funding markets (and of course positive for the dollar).

Cabana explains “As Washington has increasingly focused on tax reform, clients have asked questions about how repatriation might impact the front end of the US rates curve. While there are still many unknown elements of the plan, we believe repatriation could provide modest upward USD funding pressure for foreign banks but likely leave the overall stock of commercial paper outstanding little changed.”

There is the potential for at least $1.5 trillion in offshore funds to be repatriated, but Cabana notes that a large portion of offshore dollars are already invested in intermediate tenor Treasury, agency and corporate holdings. If pertinent legislation was passed, he believes that dollar repatriation would occur relatively quickly, as there would be limited incentive for funds to remain offshore.

Here is his view summarized...

1. Offshore USD holdings analysis shows limited allocation to very front-end of curve and EU banks largest unsecured borrowers.
   
2. Repatriation would lead to dollar funding pressure “as corporates trim unsecured bank lending, both outright and through offshore MMF.”
3. Cross currency basis swaps – notably EUR/USD and JPY/USD - would move further into negative territory with FRA-OIS spread widening by 2-6bp.

Cross currency basis swaps are negative and trending downwards, but are still some way from signalling the extreme shortage of dollar liquidity, especially in the Yen, at the end of 2016.

Cabana elaborates “The modest bank funding pressure could come as corporates trim unsecured bank lending, both outright and through offshore money market mutual funds (MMF). This could modestly widen short-dated FRA-OIS spreads by 2-6bp. It could also contribute to more negative levels of the EURUSD and JPYUSD cross currency basis given EU and Japanese financials' exposure to offshore prime MMF. A potential repatriation next year could add to existing expected funding pressures as the Treasury boosts its cash balance and the Fed's balance-sheet unwinds.”

So, there are three potential sources of pressure for dollar funding markets:

1. From rebuilding the Treasury’s cash balance (simultaneous reduction in bank reserves) on the Fed’s balance sheet. The cash balance is currently $170bn, having reached about $440bn before the drawdown.
2. Reduction in the Fed’s inventory of securities when it implements tapering.
3. Repatriation of corporate dollar holdings overseas.

As we highlighted previously, Cabana sees a large reserve drain in Q2 2018...

... when more severe funding strains are likely to emerge. Pressure in dollar funding markets will only accelerate, especially once bank reserves decline by over $1 trillion in under two years.