The Fed Reopens Dollar Swap Lines to Avert Disaster on U.S. Markets

 |  Includes: CFD, GLD, SPY, UUP
by: Kristjan Velbri

Following the €750 billion emergency fund announcements from Europe, the Federal Reserve announced that it was going to reopen the dollar swap lines for the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. This measure is supposed to help alleviate short term liquidity needs of commercial banks, in effect providing liquidity to the whole financial system.

This is something one would expect to be cheered, but for some reason, that is not the case. One needs to understand the the Federal Reserve is not trying to help Greece or any other Club Med with their sovereign debt issues, it is simply trying to avoid contagion, id est a fire-sale of US dollar based assets. The last time non-US banks faced a dollar shortage, it resulted in a massive sale of everything and anything denominated in US dollars, including gold, which is regarded as a safe haven by many (including me). Back in the heyday of the dollar shortage of 2008-2009, the overnight lending markets literally fell to pieces - the charts of LIBOR and TED spread are a living witness to that. The Fed did its best to pick it up and it did a great job at it. The dollar shortage is the only reason the cyclical bear market that began in 2007 fell way off its downtrend channel. Anyone who is familiar with the 2007-2009 downtrend knows what I'm referring to. This time around, the Federal Reserve is trying to prevent the spread of the crisis to US markets. Remember, the sovereign debt crisis, as it stands now, is still only a European problem. The US with its massive national debt has not entered the stage yet and the Fed is doing its best to prevent this European problem from spreading to US markets.

LIBOR, TED spread, US dollar

Indeed, signs of a lack of liquidity have been all over the place recently. The previous swap lines were terminated in February (January-February sell-off, anyone?), the RMBS repurchases were halted in March and the LIBOR has been climbing a steep mountain along with TED spread. During all this time, the dollar has climbed to levels last seen during April of 2009 (also seen in October 2008). Indeed, the last time the US dollar climbed so fast was after the collapse of Lehman Brothers. One might even attribute last week's intraday crash to problems with associated with liquidity, at least in part (more often than not, events like that need more than one catalyst).

All in all, it isn't the least bit surprising to see the Fed reopen the swap window. One would take it for granted that the US government and the Federal Reserve wants to maintain the dollar's position as the world's reserve currency. If the dollar's reserve status is indeed of concern to the Fed, it is only natural for them to open the swap lines. How would one expect the US to maintain that position if dollar based markets witnessed fire-sales every now and then? These dollar shortages wouldn't be a concern if non-US banks weren't so overly leveraged, but there isn't anything the Fed can do about it, really. The only thing they can do is provide short term liquidity, which is exactly what they are doing. The advantages that come with being a reserve currency are numerous, but as this is not the issue at hand right now, I would rather not go into that right now.

Of course, with swap lines and other complicated measures directed at easing liquidity constraints, one can always expect to see a surge of uneducated claims from internet discussion boards as well as from politicians. One of the many claims floating around is that the American taxpayer has to pay for this. This is not the case as these dollars will be returned as the swap lines are terminated (the deadline for the new swap lines is January 2011). As per its name, a swap implies that something is given in return, in case of the ECB, the Fed receives euros and so with every central bank. More on that here.

Most of the concerns, claims and accusations about the swap lines have been addressed in the FAQ sheet provided by the Federal Reserve, which can be accessed here. For additional information on swap lines, see my previous post and my report on the previous dollar swap lines.

Disclosure: Long S&P 500 (in CFD), long gold and silver bullion.