Snap Reactions To Central Bank Coordination Efforts

Includes: ERO, UDN, UUP
by: Tom Guttenberger

Markets shot higher on the heels of a couple of very significant news items today - China's decision to decrease reserve requirements and the coordinated action taken by the Fed, ECB, BoJ, BoE, Bank of Canada and Bank of Switzerland to lower dollar swap lines from 1% to .5%.

I will focus this post on the lowering of dollar swap lines.

Here is the a blurb from the Fed press release:

The Federal Open Market Committee has authorized an extension of the existing temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank through February 1, 2013. The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.

U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.

The move can be interpreted as a loosening of the entire global monetary policy. By allowing other central banks to swap into dollars at a lower rate, the Fed allows the counter-party central bank's currency holdings to be adjusted dynamically at a lower cost.

An important point to note is that this is in no way a bailout or a necessary liquidity-injecting move. The effect is purely second order - by allowing central banks to diversify their currency holdings at a lower rate, and presumably more often, it creates protection mechanisms against a single-currency panic scenario. This is why the euro rallied huge off of this news - the message was essentially that by decreasing the set rate for currency swaps, a one-currency disaster scenario is greatly reduced. This implies a more stable situation in terms of forecasting aggregate demand in the eurozone, the currency the panic has been focusing on.

After lowering the baseline swap rate, the USD traded significantly lower against all of the major pairs. This is because the perception of safety in the USD. By allowing other central banks to increase their exposure to the world's foremost reserve currency (~41%), they inherently add credibility to their own accounts.

The twist lies in the fact that the USD is still less valuable on a trade-weighted basis. If other central banks are able to acquire dollars more easily it allows them the flexibility to also devalue their own central bank holdings. If you accept that the long-term trend of the dollar is down - this is something that the BoJ and Bank of Switzerland have expressed interest in.

Now that I've outlined the notable positives of the action, my general view is that the move isn't actually that impactful in terms of the quoted goal of the central bank - an increase of liquidity. A link to the ECB's databook is available here. As you can see on pages 28 and 29, the status of European consumer credit and money supply liquidity situations don't seem that dire at all. To call the move today a "liquidity boost" is a misnomer. In fact, the move is a preventative measure to prevent contractions in liquidity. The preventative mechanism is, and I reiterate, the flexibility allowed to central banks to diversify their assets at a lower rate and mitigate the effects of a single-currency panic (the euro).

From the standpoint of GIIPS sovereign bonds, the advantage is the same: They are able to diversify their own assets to prevent a panic in their debt. The obvious problems that still remain are the PPP/trade imbalances within the same fixed exchange rate currency. Whether the market continues to run on the debts of certain sovereigns is anyone's guess. The recent sovereign debt run could have happened at any point, and conversely could calm at any point. Market sentiment is completely in control of the issue, and if the market gets back to shorting GIIPS debt, the aggregate demand situation is still in trouble in an all-things-equal scenario, based solely on higher total government financing costs.

The Bottom Line

The market loved the central banks' decision because it allowed them greater flexibility, and it reduced the chances of an aggregate demand disaster based on a panic in one currency. Reduced friction in the currency swaps market should help mitigate impacts of panic scenarios. The structural problems in the euro still remain, and the U.S.' ~3% GDP trade deficit also remains. Multinationals with earnings exposure to Europe took a sigh of relief today, and earnings denominated in fundamentally-strong, emerging market currencies are still the best companies to own.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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