Central Banks Pump Money To Prop Up Europe

by: Daryl Montgomery

Exactly three years after Lehman Brothers filed for bankruptcy and almost brought down the global financial system, central banks in North America, Europe and Asia engaged in a coordinated money pumping operation to prevent the EU banking system from stalling. The move created a sharp stock market rally, especially in financial shares, just as was the case when similar actions took place during the 2008 credit crisis.

Involved in Thursday's action were the U.S. Federal Reserve, the ECB, the Bank of England, the Swiss National Bank and the Bank of Japan. The purpose was to improve dollar liquidity among European banks struggling because of the Greek debt crisis. The credit markets have frozen up, just as they did after the Lehman bankruptcy, and U.S. banks have been unwilling to lend dollars to European banks. The ECB will now be able to access dollars by swapping assets with the Federal Reserve. It wasn't stated in the announcement what assets were involved, but obviously they are substandard ones that wouldn't be accepted in free market trading. This operation also increases exposure of the U.S. financial system to the new credit crisis in Europe.

Such coordinated money-pumping operations are a sign of desperation on the part of the authorities. They were commonplace after Lehman's bankruptcy on September 15, 2008. They created significant volatility in the stock market back then as they did yesterday. Both the German DAX and the French CAC-40 closed up more than 3%. Troubled banks had huge rallies, with Lloyd's Banking Group up over 7%. In 2008, even greater volatility took place, but the rallies proved time and again to be only temporary. The market ultimately nosedived.

The Friday before the Lehman bankruptcy, the S&P 500 closed at 1251.70. Lehman declared bankruptcy on Monday. At the end of the week, the S&P 500 closed at 1255.00. The day before, however, the S&P rallied off of its intraday low of 1133.50 to a close of 1206.51 (that's a 6.4% intraday rally - an enormous move for an index like the S&P). So, the first week after Lehman's bankruptcy it looked like the market wouldn't be impacted that much. It turned out that the actions of central banks provided investors with a false sense of security however.

By the end of September 2008, the S&P 500 closed at 1166.36. Then at the end of October it was down to 968.75. At the end of November, it had dropped to 896.24. It actually closed higher the last day of December at 903.25, before falling to 825.88 at the end of January. By the close of February, the S&P was trading at 735.08. It finally bottomed at 666.79 on March 6, 2009. All along the way, there were big moves up that coincided with the latest money injections of the central banks.

While mainstream media reports tend to portray the central bank actions and the big rallies they cause as good news for the market, they are actually an indication that more trouble is on the way. All investors have to do is remember what happened just three years ago. Yesterday's central bank action indicates that more volatility and lower stock prices are in our future.

Disclosure: None.