To the casual observer the global economy looks remarkably stable. US equities hover near record highs, Europe has avoided a deep recession and Asia’s export engines are slowly reviving. Policymakers celebrate what they call a “soft landing”. But to those watching the plumbing of the financial system — the crosscurrents of liquidity, collateral and dollar funding — the picture looks far less serene.
Across major money markets liquidity stress signals are flashing. Overnight funding rates are drifting towards the upper end of the US Federal Reserve’s policy range, usage of the Fed’s standing repo facility has spiked above $15bn and large dealers are showing an unusual reluctance to lend cash overnight. What appears to be a healthy, functioning market on the surface is increasingly dependent on emergency support in the shadows.
Liquidity illusion
The underlying issue is structural. The Fed’s ongoing quantitative tightening (QT) has withdrawn more than $1-trillion from the financial system. Bank reserves — cash held at the Fed that lubricates lending — have fallen below $3-trillion, a level that historically signals strain.
Meanwhile, the US treasury is issuing record volumes of short-term bills to rebuild its cash buffer. Those bills are being snapped up by money market funds, draining liquidity from banks and dealers that rely on the same cash to finance day-to-day operations. The result: an invisible crowding-out effect. Government borrowing is displacing private sector liquidity.
This dynamic has global consequences. Foreign institutions, from European insurers to Asian conglomerates, fund themselves through synthetic dollar liabilities, typically using foreign exchange swaps. The Bank for International Settlements estimates these hidden dollar debts now exceed $80-trillion, larger than the entire global bond market outside the US. Every one of those obligations must be rolled over continually. When funding tightens, the scramble for dollars becomes self-reinforcing.
Fed’s dilemma
For the Fed this marks a pivotal test of its balance sheet policy. Ending QT early would stabilise domestic funding conditions but signal a retreat from its inflation discipline. Continuing the runoff risks draining the global system of its primary reserve asset.
Either choice carries global consequences. A US liquidity squeeze rapidly exports stress abroad. A rising dollar increases the debt burden for emerging markets that borrow in US currency. It tightens global financial conditions, depresses commodity prices and drains capital from frontier economies.
Signs of dollar scarcity are already surfacing in Europe and Asia. Euro-dollar funding spreads are widening. Japanese institutions, major holders of US treasuries, are repatriating funds to offset hedging losses. In emerging markets the cost of offshore dollar borrowing is rising sharply, echoing conditions last seen before the 2013 “taper tantrum”.
If the shortage deepens global investors could witness a paradoxical outcome: a surging dollar alongside falling risk assets. That would not be a reflection of US strength, but of systemic strain — the world’s scramble for collateral in a market that suddenly lacks it.
The December Federal open market committee meeting may confirm the end of QT. Markets will likely cheer. Yet the larger question is whether the system can function without ever-expanding liquidity injections. For a generation, every crisis has been met with more liquidity, not less.
From a global vantage point the risk is clear: the financial order remains dangerously dependent on one central bank, one currency and one funding channel. If that channel clogs, as it is beginning to, the repercussions will not stop at Wall Street.
In an interconnected world a dollar shortage is not an American problem. It is a global one and it is quietly building beneath the surface of the strongest market on earth.
• Muchena is founder of Proudly Associated and author of ‘Artificial Intelligence Applied’ and ‘Tokenized Trillions’.
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