Cross-currency transmission of money market tensions
Financial Markets Department
Kei Imakubo, Takeshi Kimura, and Teppei Nagano
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Funding conditions in global money markets have tightened since August 2007. In various currency-denominated money markets, term funding rates have come under upward pressure because of heightened concerns about counterparty credit and liquidity risks. Although the magnitude of upward pressure on interbank rates has differed across markets, the direction of its movements has followed a similar pattern. In this Review, using a vector autoregression model, we analyze the cross-currency transmission mechanism of term funding premia across the US dollar, euro, and Japanese yen markets. We find that the increased volatility in these markets results from not only changes in the variances of shocks impacting the market but also changes in the structure of the market. Under heightened uncertainty about US dollar funding, the interdependent relationship across these markets has strengthened via cross-market rebalancing activities of risk-averse financial institutions. In addition, market liquidity of the foreign exchange (FX) swap deteriorated after August 2007, which made it difficult for FX swap markets to mitigate the dislocation of US dollar liquidity. As a result, shocks for US dollar funding were not efficiently absorbed in global money markets, and the FX swap implied dollar rates from euro and yen were under persistent upward pressure. This strain in the FX swap markets was then fed back into the unsecured US dollar market, leading to further upward pressure on US dollar interbank rates.
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