This morning, a group of central banks, including the Fed, announced coordinated action to ease the cost of currency swap lines in Europe.
Essentially, these are facilities that allow local banks to borrow in dollars or yen or what have you from their central bank, with the ECB getting the money from the central bank that controls the currency in question.
While this is billed as a coordinated global action, this is really about dollars, and the Fed. No other currency is seeing that much excess demand.
This is a band-aid. It's a good band-aid. But making it easier for local banks to borrow in dollars does not, in the end, fix any of the problems with the euro-zone. It just delays the rate at which the current sovereign crisis turns into a banking crisis. RBC analyst Mark Cloherty sums it up in a research note this morning:
Note that it is now cheaper for foreign banks to borrow dollars from their local banks than it is for US banks to borrow dollars from the Fed, so we could see a 25bp cut in the discount window in the coming days to level the playing field.
Again, we look at this facility as eliminating the liquidity element of LIBOR (banks don't need to be as afraid of lending term because they know they have a backstop liquidity source that won't be that expensive, which means the money market curve stays flatter) rather than thinking that LIBOR will move all the way to the new ceiling. So we think LIBOR can still creep a bit higher than spot, but it will be difficult to get higher than 60bp.
In addition, the other central banks are setting up bilateral lines (sterling for Euros, etc) , although we don't expect those facilities to be used in anywhere near the size of the dollar facilities so we don't expect any significant impact.
This is a very big deal if you are trading Eurodollar contracts as the Fed was more aggressive (we thought they would go to OIS+75bps rather than OIS+50bps), but it doesn't change any of the fundamental issues in Europe. The major help to risk assets is that those investors no longer will need to see LIBOR rise relentlessly (and it should make year-end a little less messy), but we don't think this is a real game-changer.
And the fact that it was necessary (and provided such a big boost to markets) supports Karl Smith's argument that the ECB has lost control over local monetary policy:
Based on entirely different indicators this looks to be the point where the ECB's control over Eurozone monetary policy began to come unmoored.As he notes in a later post, "How long ago was China's primary focus curbing inflation and re-balancing the export driven economy. Was that two months?"
At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market.
This malfunctioning appears to be down right mechanical with trades regularly not settling on time, collateral not being delivered, awkward interventions by local regulatory agencies and a host of other deep, deep problems.
I don't have it all sorted out but its not clear that there is a fully functioning money market in Europe right now. Well informed opinion suggests that there is literally a shortage of know-how on the ground. That is to say, some large banks or brokers cannot trade in certain types of paper because they don't have anyone on staff who knows all of the relevant institutional details.
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