As the FX World Turns - The 2022 Episode

Global Exchanges - 11-22 v2 Page 1 of 7 Greg Anderson: Hi. Welcome to episode 57 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host Stephen Gallo and I will be joined by BMO FX Forwards Trader James Topham. The topic of our discussion will be so-called turn pressures that are manifest in the interest rates implied by FX forward points in various currencies. The title for this episode is As The FX World Turns: The 2022 Episode. Stephen Gallo: Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets. Greg Anderson: Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host. Stephen Gallo: In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities. Greg Anderson: We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us. Stephen Gallo: Okay, welcome to Global Exchanges episode 57. Thanks for tuning in. It's November 22nd 2022 and today we're joined by James Topham, as Greg Anderson noted, for an in-depth discussion on the FX forwards market, funding conditions and other factors we don't normally talk about on Global Exchanges as we head into the turn of the year, the end of 2022. So, James is part of the Digital and Liquid Trading Group in BMO FX, and as Greg noted in the main intro to this episode, he has extensive experience trading forwards. James, welcome to Global Exchanges. James Topham: Thank you. Stephen Gallo: And just for background, we had James with us before on Global Exchanges a little less than a year ago to preview the 2021 turn. So this is James second hit on global exchanges. We'll have a lot of interesting things to talk about today. Right. So Greg, global head of FX Strategy, that's who you are. Why don't we start off with you and your line of questioning for James. What do you have to ask him? Greg Anderson: James, thanks so much for joining us. Last year, when we had you on for the 2021 episode of As the FX World Turns, you said something that I thought was super insightful and fascinating. You said that for 2021, you felt like any turn pressures were more a result of greater excess liquidity in other currencies than the dollar, and not so much an issue of tight liquidity in DUSD. So New Year Global Exchanges - 11-22 v2 Page 2 of 7 2022, and I want to ask you if you still hold that view or has the Fed's QT changed who we should "blame" for any turn seasonality that manifests itself? James Topham: Good question. I think that it's certainly still the case that most of the turn effect comes from excess liquidity in the non-dollar currency. And financial institutions and other market users need to shrink their balance sheet in all these other currencies. It is true that with Fed tightening, dollar liquidity is leaving the system, albeit gradually, but we are certainly not at the point yet where dollar liquidity is tight. We haven't reached that point yet. We will at some point, probably next year. But no, it's still very, very much the case that the problem is, for example, parking your yen, parking your euros, parking your sterling somewhere. That's the thing that causes the turn, definitely, not the fact that people are scrambling for USD. Greg Anderson: Thanks for that response, James. Another follow-up question to last year, you said last year that you didn't think that turn pressures in the FX forward market spilled over to the spot market, at least for 2021. So I want to explore that for 2022, but my first question for you is what date did the three-month FX forward first span across the turn? James Topham: That would've been 29th of September, probably. Yes, 29th I think. Greg Anderson: Okay. And then the two-month would expanded on what date? James Topham: Likewise something like 28th of October, just so where your typical T+2 spot date then goes into the new month. So, something like 28th of October for the two months. Greg Anderson: Okay. Then the contract, which I kind of presume would have the biggest action, the one month, that'll span the turn on... What date is it? James Topham: Next week, 29th of November. That's when the one-month will roll over. Greg Anderson: Okay. So on this issue, I guess I will point out that we started to see bits of pressures in the forward market, like 25th and onwards or whatever in September. And in the spot market, the 28th of September was the index high for US dollar index. So we did see this upward surge in the dollar, right as that three-month span turned. James, in your view, is there any causation or is that just a pure coincidence? James Topham: Good question. I think just a coincidence, Greg, as I mentioned last year, although in percentage, annualized yield terms, the turns are enormous. If you look at the actual points cost of hedging the turn or not, it's still relatively small compared to daily, weekly volatility spot ranges. So I really don't think that at these kind of levels that we've experienced in recent years, it can affect the spot. I don't think so. So I do think that's just a coincidence. Global Exchanges - 11-22 v2 Page 3 of 7 Greg Anderson: And I'll defend your answer by pointing to that when we had the two-month span in late October, there was zero upward impulse in the dollar on that date. James Topham: Mm-hmm. Greg Anderson: So James, last question from me, at least for now. When I think about the turn phenomena, the first pair that comes to my mind as dollar-yen. So if I could ask, I want to ask you how things are evolving dollar-yen this year. So first off, how illiquid has the dollar-yen forward market been headed into calendar year end? And how exaggerated were the moves in implied yields in dollar-yen when we had the three-month span, the turn, and the two-month span, the turn? James Topham: So liquidity wise, things have been okay. Spreads are a bit off, spreads are a little wider if they encompass the turn just because it's a little more volatile and dealers are a little bit wary of pricing and holding that stuff. But actually, it's been pretty good. Liquidity's been pretty there. There's been no bad days, no bad episodes that I can recall. Things have been functioning quite well. And to your question about levels of dollar-yen, the turn, it's been big, several hundred basis points as usual. But actually, in recent days, it's been tightening up a bit, normalizing along with the other currency pairs. We do expect some more dollar borrowing flows to come around month end, the one-month roll that we mentioned before. And also sometimes you get a wave of flows as you come up to mid-December for the roll of the CME contracts, the December to March roll. Obviously, that goes over the turn. That's a wave of flows that can push things around as the market digests them. But I would say it's possible that we've already seen the widest levels this year for this season. Greg Anderson: Thanks so much, James. That's really insightful. Solicitor Gallo, your witness. Stephen Gallo: Okay, thanks for the handoff, Greg. James, I'd like to briefly cover Europe in general. And to do that, I want to concentrate first specifically on funding conditions for euro-based banks. Have we seen any stresses in this regard for European-based banks in terms of their dollar funding needs or their costs? James Topham: I would say not, depending on how far back you want to go, let's say to the pandemic. There were some weeks of real stress in the market when people were unwinding risk and retrenching, so there was some panic in funding at that time, but then the central banks threw the kitchen sink at everything and things calmed down very quickly and they remained calm until the Russian invasion of Ukraine. Again, a few days of panic, which quickly subsided, but pretty much the European Bank seem to be in pretty good shape. Stephen Gallo: Okay. Global Exchanges - 11-22 v2 Page 4 of 7 James Topham: As you can see, for example if you look at the Fed swap lines, this kind of stuff are unused, pretty much. And general levels of euro across currency basis are pretty normal, pretty tight. Stephen Gallo: So I guess what you're saying is if bank balance sheets were in the shape that they were in prior to the global financial crisis today with the war in Ukraine and energy crisis, high inflation and monetary tightening, things could be much, much, much worse. James Topham: Things could be a lot worse. Yes, indeed. Stephen Gallo: Yeah, makes sense. The second line of questioning has got to involve the UK because the moving sterling, the dislocations in the UK government debt market, these are some of the big macro events of the year. But despite those dislocations and the moves that I just mentioned, it looks like we didn't see very much anything in the cross-currency basis. Funding conditions for UK banks remain pretty stable. What do you think has been going on there? Why so much calm? James Topham: Yes, great question. Because when all that stuff was kicking off, these are the kind of events which typically would have a widening effect on the crosscurrency basis, especially for a market like sterling. So it was very interesting that we didn't see any widening at all. I'm really not sure why that is. It's possible that although the gilt market was seriously affected, perhaps UK banks just not carrying that much gilt inventory these days in their market-making books, perhaps their balance sheets are just so much more solid post financial crisis. I'm not sure. But yeah, certainly the basis could have widened, maybe classically you would say it should widen, but we saw no such move, not even a short term panic with a quick retracement. Just, it didn't move. It was quite unusual. Stephen Gallo: Yeah, it's very unusual. It's fascinating. I wonder, though, if it's worth considering that had the events that took place in the UK gone on for a number of weeks and things weren't corrected as quickly as they were, is it possible then there would've been some reticence non-UK banks lending foreign currency dollars to UK banks? I wonder if that's possible. James Topham: That's a good point. Perhaps it was because although it was a deep crisis, perhaps it only seemed to last a week or so before things were recovering. So perhaps it was that, so then perhaps the damage to the system and perhaps the exit from the gilt market was more the faster money, those LDI-type funds and there wasn't this... Stephen Gallo: It's the counterfactual, right? Global Exchanges - 11-22 v2 Page 5 of 7 James Topham: Yeah. Stephen Gallo: What would've happened if the Bank of England didn't start to step in and buy bonds? James Topham: Perhaps they saved the day. Stephen Gallo: Perhaps they saved the day, who knows? Okay. My parting shot, James, so to speak. We were on euro, we did sterling, we're going to migrate over to the Swiss franc. James, my understanding from observing the London Forward Desk over the last few weeks is that volatility in Swiss franc rates and the cross-currency basis have been big issues for traders like you. What's been going on there? Does it have anything to do with the massive size of the S&B's balance sheet or its attempts to tighten monetary policy? And what do you think has been the impact on the spot level of the Swiss franc, if any? James Topham: Yes. Swiss has been in a world of its own, really. Since the S&B have hiked rates into positive territory, you've really seen the cross-currency basis has widened quite a lot in Swiss. Even, not just the turn, but just regular funding. You can think of it in terms of that the rate hike has not been fully passed through into the FX swap market. Kind of a leaky plumbing, as I call it, in the system. Now, almost certainly that's to do with the sheer size of their balance sheet, the excess liquidity. Could also have been partly to do with the length of time that they were on negative rates. It's harder toStephen Gallo: Get out. James Topham: It's harder to adjust if you've spent more time in a different regime. And also, let's not forget that one of their major commercial banks is pretty much pulled back from the international markets, which again, can't help with pass through and intermediation. A big commercial bank with access to the S&B facilities that then trades with international banks is an important way that liquidity in the system is recycled. So it can't help that they used to have two big banks and now they've got one, pretty much. Stephen Gallo: Pretty much. James Topham: Yeah. Stephen Gallo: And what about the spot market? Any spill over to that? Global Exchanges - 11-22 v2 Page 6 of 7 James Topham: Not that I've noticed. I think that seems to be more risk appetite, Ukraine focused. Stephen Gallo: Okay. And then just for my clarification, for the sake of clarification and for our listeners, those who are interested, during these episodes of volatility in Swiss franc rates and the cross-currency basis, would it actually have been difficult for Swiss banks to raise dollars or would they have had to pay up significantly more so than other non-US banks or really didn't go down that channel? James Topham: Again, no. I would say that it's more of a problem with international banks being unable to park their Swiss at rates close to S&B policy rates. Stephen Gallo: So it's more of a big headache for the Central Bank. James Topham: Yes, absolutely. Stephen Gallo: Right, okay. Got you, understood. James Topham: Rather than that. Yeah, I don't think it's... I haven't seen any pressure on the dollar from them. Stephen Gallo: Interesting, interesting. So Greg, Mr. Anderson, that's basically my laundry list complete for James. Do you have anything else that you want to throw at him before we let him go? Greg Anderson: Yeah, James, while we have you, just one last question. You mentioned that November 29th, a week from today, is the date when the one-month contracts span the turn. And I guess my final question, do you have any insights for us and for our clients on what to expect for that date? And in particular, which currencies are you nervous about? James Topham: It's a tricky one. I've read some opinion pieces from some banks who say that because the net flow is going to be borrowing of dollars, people say it's going to widen because of X, Y, Z reasons. But equally, you can read pieces by other banks who say it's going to tighten for A, B, C reasons. So really the problem is always, you can come up with good reasons why it's going to move one way or the other, but the market is so big and complex and no one has enough visibility over enough of the market to say where we will go from where we are. The euro turn has already been quite wide by recent standards. And I think I mentioned before when I was answering your question about yen, that it's possible that we've already seen the widest levels and the normalization that we tend to get as we approach New Year's Eve. It could already be underway. Global Exchanges - 11-22 v2 Page 7 of 7 But that being said, there are reasons that I've read that euro is still one to worry about from where we are. Particularly, they didn't get the TRO repayments figure that they wanted. So euro excess liquidity/collateral shortage is still a big problem for them. Now, I've read that from one European bank says that the ECB, they might consider introducing some kind of certificates of deposit or this kind of thing to withdraw liquidity. That would be a bit of a game changer. That would cause the turn to normalize, all else being equal. But yeah, it's all still up in the air. I think you've just got to stay nimble and just roll with it. Stephen Gallo: Roll with it. I think that's pretty much where we should wrap up, Greg. There's so many thoughts rolling around in my brain. I'm sure you too. What do you say? Greg Anderson: Yeah, I think this is probably where we should end it, but just a big thank you to James for coming on the podcast with us. Stephen Gallo: I'll second that. Thanks a lot, James. We hope to have you again some time pretty soon. James Topham: Soon. Yeah, that's a pleasure guys. Thanks. Greg Anderson: Thanks for listening to Global Exchanges. Listen to past episodes and find transcript at bmocm.com/global exchanges. Stephen Gallo: We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify or your favorite podcast provider. Greg Anderson: This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative. Voiceover: The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.