Posts Tagged ‘bryan rich’
Fed’s Currency Swap Lines: A BIG deal for the Dollar
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The Fed met this week on monetary policy. It was a bit of a snoozer. What wasn’t a snoozer, however, was what they’ve included in their recent monetary policy statements regarding currencies.
Most market participants have been entranced by the Fed’s language about their target interest rates …
Will they say they’ll keep rates low for an “extended period” or not?
But the real story was buried in the last paragraph of the December Fed statement and reiterated in their latest statement.
Here’s what it said …
“The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1.”
Following the Fed’s statement this week, there was a coordinated release of comments from the European Central Bank, the Bank of England and the Swiss National Bank confirming that the swap lines were no longer needed.
For the currency markets, this is a big deal. Yet, few have thought the juicy details of the Fed’s plans on currency swaps are of interest.
But I do. I suspected it was a game changer for the dollar when I was studying the statement last December. And so far, the price action in the currency markets is confirming that.
Here’s a bit of background …
In September and October of 2008, the Fed announced that it would be opening temporary currency swap lines with central banks around the world in fixed amounts through April of 2009. As that expiry date neared, the Fed extended the period to October, and then extended it again until February of this year.
Here’s what that means: The Fed agreed to give foreign central banks U.S. dollars at a determined exchange rate for the currency of the respective foreign counterpart. And when the swap ends, the two central banks simply repay the same quantity of currency back. There’s no exchange rate risk and no impact on the demand for currency in the open market.
Why Did the Fed Offer Dollars to the Rest of the World?
When the credit crisis was at its peak, banks around the world were hesitant to do any short-term lending with other banks. As a result foreign bank-to-bank lending rates for dollars, the world’s primary business currency, shot up. That restricted access to dollar borrowing and pushed a lot of consumer interest rates higher in the U.S. and abroad.
By providing these currency swaps with other central banks, the Fed helped to inject dollar liquidity into banks around the world. And it was well needed.
In short, it was good for the global financial system because it helped reduce the fear premium that was causing market interest rates to soar.
You can see this clearly in the chart below. In panel A, while the Fed and other central banks were cutting benchmark interest rates to the bone (the white line), the Libor rate (the orange line), or the rates at which banks make short term loans between themselves, was going in the opposite direction.
Subsequently, when the dollar swap lines were rolled out, you can see in panel B how this divergence was reversed.
The Implication for Currencies
Most importantly for currencies, what these currency swaps did was increase the supply of U.S. dollars in the global markets — a negative drag on the value of the dollar.
So with the Fed announcing that it will close its currency swap lines with foreign central banks by February 1, the unlimited access to dollars by foreign central banks has come to an end.
This development is easily a positive for the dollar.
Let’s take a look at the timeline of these developments and the respective performance of the dollar …
As you can see from the chart, following the Fed announcement that the swap lines would be extended through October, the dollar has gone through a period of decline. Since December, when the Fed announced these facilities would be ending in a little more than a month’s time, the dollar has been on the rise.
When they opened these massive swap lines in late 2008, the goal was to alleviate the dollar liquidity crunch at banks around the world. However, in the process they increased the supply of dollars around the globe — a negative consequence for the value of the dollar. But now that these lines will be closed, it’s clearly a dollar-positive development.
And with the weight of evidence leaning in favor of the dollar at this stage, as I laid out here in my article last week, this latest announcement by the Fed provides more reason to believe in this dollar rally.
Regards,
The Fed’s Perfect Scenario
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If you consider all of the structural problems in the U.S. economy, there has not been a lot of progress toward getting things back on track. The root causes of what created the near debilitating financial and economic crisis still remain:
Banks are still saddled with toxic assets,
Housing prices are still 30 percent lower,
Foreclosures are still hitting new record levels,
Credit is still tight and demand for credit is still contracting sharply,
And now …
The U.S. government has thrown trillions of dollars at the problem. And the actions they’ve taken, for the time being, have helped to avoid a collapse of the financial system that would have caused a massive run on banks, a standstill of economic activity and a worldwide economic depression.
There are plenty of areas to question and debate the decisions made by the U.S. Treasury, the Fed and other government types. But the stabilizers and backstops, to this point, have managed to avert an economic freefall. Of course, the ultimate outcome of policy actions has yet to be determined.
But it’s clear that the U.S. and economies around the world remain fragile.
Even so, people are grasping tightly to the idea that a sharp bounce back is in progress and that a return to normalcy is near.
For the Fed, it’s this type of optimism that is driving a perfect operating scenario.
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| Government action has averted financial disaster, but global economies remain fragile. |
What Is the Fed’s Perfect Scenario?
If the Federal Reserve and the U.S. Treasury could have scribbled out a wish list for financial market conditions last March when global economies and global markets were in freefall, it might have looked something like this …
Wish #1: Please give us rising stock prices.
Rising stock prices improve the sentiment of investors and consumers. They replenish some lost paper wealth and make companies feel better about the future. It’s amazing what a 64 percent rise in stock prices can do for confidence.
Wish #2: Please give us stable interest rates.
Demand is massively depressed by things like evaporated consumer wealth, tight credit, and high unemployment. And deflation has been, and remains, the immediate problem.
The Fed’s answer: Zero interest rates and “printing money.” These tools are at work to prevent a deflationary spiral and to influence low mortgage rates to curb the housing implosion.
But consumer credit and mortgages are priced based on market-driven interest rates, not rates set by the Fed. So a move higher in market interest rates, like interest on 10-year Treasury notes and Libor, would create a big problem for the Fed. It would drive up interest rates on consumer credit and mortgages, which would create even bigger problems for consumers and for the housing market. But that hasn’t happened.
Wish #3: Please give us stable commodity prices, especially oil.
Crude oil is down 50 percent from its high a year ago. In a period where consumers are more inclined to save, not spend … stable gas prices are critical.
Wish #4: And a gradually declining dollar wouldn’t hurt …
This is the icing on the cake. Even if global demand for everybody’s exports is still in the gutter, the effect of a weaker currency on GDP is a nice kicker. A weaker dollar means we import less and perhaps we export a little bit more … but most importantly, the net value that comes from importing less and exporting a little more is a key positive contribution to GDP.
Despite all of the fear about the future of the dollar, it’s important to realize that a weaker currency is actually good for an economy when economic growth is depressed. Our trade balance is narrowing and our current account balance has diminished dramatically.
Now, when the economy is growing at a healthy rate, then a stronger currency is preferred because it helps improve quality of life.
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| A weaker dollar is actually good for a depressed economy because it helps narrow trade and account balances. |
A Gift Without Staying Power
By coincidence, or not, all the Fed’s wishes have come true. And this confluence of gifts from the financial markets has bought some time to address some of the structural economic problems. But the structural problems haven’t been repaired.
Financial markets are rarely compliant to wish lists, especially when the performance defies fundamentals. At some point, the markets will find fundamental equilibrium.
The key question is: When will markets revert to reality?
That’s the hard part.
The U.S. stock market continues to be the gauge of how investors feel about the prospects of a sustainable recovery. Higher stock prices equal more optimism. And more optimism equals higher risk appetite.
But at this stage, the idea of chasing returns that are not supported by fundamentals is a high-risk, low-reward proposition. And it’s not hard to find a reference point of the type of pain that can be associated with the divergence between market prices and fundamentals.
It was only twelve months ago that currencies, commodities and stock markets made sharp and abrupt collapses.
As for the Fed and the Treasury’s wish list … when the rise in stocks ends, so will confidence and any hopes for a sharp economic recovery. And when confidence wanes, investors feel more risk averse.
What Does That Mean for Currencies?
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| Fears of the dollar’s demise may be premature when compared to other currencies. |
Despite all of the ugly issues surrounding the U.S. economy, it will have among the smallest of economic contractions in 2009 compared to other G-7 countries, second only to Canada. And for 2010, the U.S. is expected to outperform all other major developed market economies.
That says something about the state of the rest of the world.
And when it comes to the dollar, and currencies in general, you have to respect the relative nature of currency values. Currencies don’t operate in a vacuum.
A country’s currency is never valued based on how well or how poorly its particular economy is doing in isolation. It’s always measured against another country’s currency. So it is always valued based on how a particular economy is doing relative to another economy.
For those that are fearing darker days for the dollar, remember that the least ugly currency can still win the beauty contest. Also, any rise in risk aversion is a positive for the dollar.
Regards,
