HomeShrinking USD Liquidity to Influence FX Flows

Shrinking USD Liquidity to Influence FX Flows

Since the start of the COVID-19 health crisis, central banks around the world flooded markets with new money to help businesses and the population cope with the new challenges. However no central bank has been as proactive as the Fed has been thus far. 

The USD swap lines, together with the massive increase in its quantitative easing program, were enough to create massive USD liquidity that helped financial markets ease the tension. However, the USD liquidity is shrinking fast, despite the Fed’s actions.

Two Forces Influence the USD Liquidity

On the one hand, the Fed has the ability to create new money by printing it digitally. The process, dubbed quantitative easing, involves buying US bonds in an effort to bring down the yields.

On the other hand, the US Treasury suddenly sits on a pile of USD. If the rate the US Treasury is hoarding the money exceeds the pace of the Fed printing, the net effect is a decrease in USD liquidity.

For the currency trader, it is important to understand all the facets of monetary policy. While true in many other cases, USD printing alone is not enough to weaken the currency. It may work in the case of other central banks, but the USD is the world’s reserve currency, and things like trade flows play a crucial role in the demand and supply balance.

In other words, while the Fed expanded its balance sheet (USD negative), the world trade shrank at a fast pace (USD positive) in the last month. On top of that, the Treasury sits on over $1.5 trillion that it did not deploy as of yet. If the Treasury issuing continues to outpace the Fed’s digital money printing and the world trade improves (as it should be due to a pickup in economic activity), we have perfect conditions for a higher USD in the period ahead.

Of course, there are too many variables in the context, and trading based on fundamental analysis is never that easy. Due to the Presidential elections later in the year, we should not rule out the Treasury unleashing the funds in the second half of the year in an effort to impress voters.

Such macro-themes need time to play out. Any positioning from a fundamental perspective makes sense in the context of a several months investment horizon that should span beyond the US election.

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