BIS data shows not just this surge in swap-related dollar debt but also how swaps dominate the FX market. 

Undoubtedly, "losing" USD 97tr in FX swaps, currency swaps, and forwards would be alarming. But it is not "lost" in a physical sense. What the BIS means is that it is "lost" as far as regulators are concerned, as this off-balance sheet activity is largely hidden, and that’s of importance as such off-balance sheet dollar debt is about double the on-balance sheet debt of non-banks outside the US.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the BIS has warned about this for many years. So far, these fears have not materialized, and they may never do so in the future. But that’s not to say that the BIS’s analysis is worthless; in fact, it may prove more valuable in helping to determine how the dollar may trade.

BIS data shows not just this surge in swap-related dollar debt but also how swaps dominate the FX market. In April 2022, around 50% of daily FX turnover was in FX swaps; the spot market was under 30%. This is why Mr. Steve Barrow argued that, in trying to determine how currencies (and particularly the dollar) move, we should be thinking about the swap market, not the spot market. This is an important thought process because we then see the dollar as not so much a function of the traditional fundamentals that might determine how attractive the US currency is relative to another but, instead, a function of the ease, cost, and attractiveness of borrowing dollars through the swap market.

The BIS, for one, is most alert when the costs of dollar borrowing through the FX market soar, as reflected in cross-currency basis swaps. Such episodes are usually associated with crisis periods when asset prices tumble. When this happens, dollar borrowers, such as international investors, can end up being overhedged because their short dollar positions in the swap market become too large given that the investments they are funding, such as stocks, are collapsing in value.

To correct this overhedging, dollars are often bought back in the spot market, and that’s partly why the dollar usually surges when major risk-off events occur. Again, the BIS has detailed these in the past and also noted the way that policymakers have tried to deal with this hidden dollar debt problem by, for instance, utilizing central bank FX swaps between the Fed and other major central banks. These swaps provide dollars to international markets, easing some of the pressure on cross-currency basis swaps.

"The upshot of this discussion is that the dollar tends to surge when a major crisis happens, like COVID or the financial crisis." This may not help us much when it comes to forecasting the dollar because it then relies on our being able to pinpoint future crises, which is all but impossible. However, outside of crisis periods, it does seem to us that this overhedging through the FX swap market when asset prices are generally falling could still tell us much about future dollar direction. For instance, if we take this year, there hasn't been a major crisis in asset prices with stocks plummeting in the way we saw during the height of COVID. "Asset prices have still fallen steadily in both bonds and stocks, and our view is that this has still led to overhedging of positions and, most likely, resultant demand for dollars in the spot market that has pushed the greenback up," said Mr. Steve Barrow.

However, as well as overhedging when asset prices fall, we can envisage underhedging when asset prices rise, and these periods will presumably be associated with dollar weakness, not strength. "Looked at in this way, the key question going forward for the dollar is whether the recent asset price strength we’ve seen will continue next year. That’s hard to say, but we do find it hard to believe that we’ll see another year as bad as 2022. "If that’s correct, the dollar seems most likely to either tread water next year or fall—and our money’s on the latter," emphasized Mr. Steve Barrow.