Fed Backstop Fears Could Threaten Dollar, Deutsche Bank Says

(Bloomberg) — The withdrawal of a time-tested liquidity backstop offered by the Federal Reserve would represent the greatest risk to the dollar’s status as a reserve currency since the end of World War II, according to Deutsche Bank.

European central banking and supervisory officials have held informal discussions about the possibility that the Trump administration will push the Fed to step back from global funding markets in times of market stress, Reuters reported this week, citing unnamed sources. 

There has not been any indication that the Trump administration wants the Fed to scale back the so-called swap lines that the central bank has offered during past crises. But the reported conversations in Europe come as the US is stepping away from its European allies on other fronts. Even without the Fed taking action, any fears about the reliability of the swap lines could be damaging to the dollar, George Saravelos, Deutsche Bank’s head of foreign-exchange research, wrote in a note to clients Thursday. 

“Were such concerns to prevail among America’s Western allies, it would likely create the most significant impetus to global de-dollarisation since the creation of the post-World War global financial architecture,” Saravelos wrote. 

The swap lines, first launched during the 1960s, allow global institutions to borrow the greenback in exchange for their local currencies, easing demand for the dollar in times of financial stress. Revived in 2007 as the financial crisis heated up, the availability of this Fed support has long been considered an important — if infrequently-tapped — backstop during times of market turmoil. 

The European Central Bank, Bank of Japan, Bank of Canada, Bank of England and Swiss National Bank currently have standing swap line arrangements with the Fed. At the height of the market dislocations wrought by the pandemic in early 2020, the lines were also extended to other central banks including the Bank of Korea, the Banco Central de Brasil, and the Banco de Mexico. 

Saravelos noted that the Fed has sole responsibility for its programs. But, he said, the Trump administration can have an indirect influence on the central bank — either via “moral suasion” or through the figures appointed by Trump to its governing board.

Should the Fed choose to withhold liquidity support in times of immediate stress — or attempt to leverage the facility as a quid pro quo for other US policy goals — it would have far-reaching consequences, Saravelos added. The US currency would sharply appreciate as global institutions scramble for dollar funding, driving higher demand. It could also lead to “fire sales” of US assets that are often hedged in the foreign-exchange swap market. 

Most importantly, doubts about the Fed’s preeminent role as the world’s lender of last resort would “accelerate efforts by other countries to reduce their dependence on the US financial system,” Saravelos wrote. China and Russia, two major economies that do not have swap lines with the Fed, have accumulated non-US foreign reserves and de-dollarized their economies in recent decades, he noted.    

The Fed offers other facilities designed to ease liquidity issues in global markets. In March 2020, it established a repurchase agreement operation with a broader range of foreign institutions that became permanent in July 2021. The facility allows foreign institutions to exchange their US Treasury holdings parked at the Fed for dollars, instead of forcing them to liquidate Treasury holdings or tap the private repo market in times of stress.

–With assistance from Anya Andrianova.

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