US Fed Re-Opens Currency Swap Lines for Euro Rescue

See, I told you so.

Here's the press release from the Federal Reserve, as of 9:15PM EST, May 9, 2010:

"In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the re-establishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.

"Federal Reserve Actions
The Federal Open Market Committee has authorized temporary reciprocal currency arrangements (swap lines) with the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Swiss National Bank. The arrangements with the Bank of England, the ECB, and the Swiss National Bank will provide these central banks with the capacity to conduct tenders of U.S. dollars in their local markets at fixed rates for full allotment, similar to arrangements that had been in place previously. The arrangement with the Bank of Canada would support drawings of up to $30 billion, as was the case previously.

"These swap arrangements have been authorized through January 2011. Further details on these arrangements will be available shortly."

$30 billion to the Bank of Canada, unlimited amount to the Bank of England, the ECB, and the Swiss National Bank?

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Euro Crisis: US Federal Reserve to the Rescue?

I have no basis for this, to make it clear up front. Just my hunch.

As EU ministers (particularly of those 16 countries that uses Euro as their currency) try to come up with a grand plan (nuclear, bazooka, whatever) to "stabilize" the Euro before the Asian markets open for trading, people are speculating what kind of plan it will be, given the lack of details.

One speculation (or rumor) says this "stabilization" plan may include more than 600 billion Euro bonds issued by the European Commission to fund basically a bailout fund for European banks who holds underwater sovereign bonds. (See this Reuter's article that says "Euro zone sources said late on Friday that the mechanism could be funded by bonds issued by the European Commission with guarantees from euro zone states.")

My question is: Where will the money come from to buy the EC bonds? Who is going to buy them?

My hunch is the US Federal Reserve. There's a chatter about the Federal Reserve re-opening the liquidity swap lines with the ECB. At the height of the credit crisis in 2008/2009, the Fed's liquidity swap lines with foreign central banks swelled to over $600 billion.

The Fed could either extend the swap lines so that the ECB, Bank of England, and other central banks in Europe could buy these bonds, or so that they could funnel the money from the Fed to their financial institutions who would then buy the bonds with that money. I wouldn't be surprised if the Fed directly buys such bonds.

Otherwise, the money to buy these bonds would have to come from the EU member countries' savings. Talk about misallocation of capital. Instead of these capitals deployed for productive means and investments, they would have to fund the "stabilization" mechanism, a sink hole, to prop up the financial institutions.

Just so that you know, the US Treasury has raised $200 billion for the Federal Reserve since late February under the Supplementary Financing Program (SFP), which allows the Fed to use the money raised any way it sees fit to help stabilize the financial markets.

Do you see a depression coming?

If the funding of the mechanism comes from the savings of the member countries, they will (and the world will, probably) get a deflationary depression. If it comes from the Fed's printing press (or the ECB's), it will be an inflationary depression.

Take your pick. We will know soon enough. Maybe as soon as a few hours from now.

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Sneak Attack on U.S. Dollar?

or is it the result of an on-going process that started back in March?

Politico thinks this is a "sneak attack" on U.S. dollar this week.

People at Politico are not stock market or forex traders, that's for sure. Current U.S. dollar decline is mild, compared to what has transpired since March this year.

Not to be deterred by the lack of perspective, however, Politico sets to find out...

Whodunit? Sneak attack on U.S. dollar (Eamon Javers, 10/8/09 Politico)

"It’s the biggest mystery in global finance right now: Who conducted a sneak attack on the U.S. dollar this week?

"It began with a thinly sourced but highly explosive report Monday in a British newspaper: Arab oil sheiks are conspiring with the Russians and Chinese to quit using the dollar to set the value of oil trades — a direct threat to the global supremacy of the greenback.

"Is it true? Everyone from the head of the Saudi central bank to U.S. officials scrambled to undercut the story, but no matter.

"With the U.S. economy on the ropes and America by far the world’s biggest debtor, investors aren’t feeling as secure about the dollar as they used to. And the notion of second-tier economies ganging up on Uncle Sam didn’t sound so far-fetched.

"For American officials, the possibility of the dollar losing its long-term dominance in global commerce is a nightmare scenario because it would likely mean sharply higher interest rates at home and a declining ability to finance the U.S. debt. No one believes it could really happen right now, but stories like the British report this week make it seem incrementally more likely."

While trying to undermine the Independent story by casting doubt on Robert Fisk (a highly respected veteran journalist, in my opinion), the writer concludes:

Whodunit? "No one knows."

I think I have a suspect, or an event that may have contributed to the rapid decline of the U.S. dollar. Not the decline of U.S. dollar this week, but since its recent peak back in March when the U.S. dollar index was near 90.

The U.S. Federal Reserve.

It is probably just a coincidence, but it's a little more interesting answer than "no one knows".



Take a look at this chart. This is a year-to-date daily chart of the U.S. dollar index (DXY). Red arrows on the chart indicate big negative flows out of the Fed's central bank liquidity swaps, as shown on their balance sheet. The weekly change of the swaps is shown in the table, with numbers in red corresponding to the arrows in the chart. The location of the arrows is approximate, as we don't know exactly which day of the week the Fed unwound the swap.

That's foreign currencies going back to the foreign central banks, and U.S. dollar coming back to the Federal Reserve. The Fed is not saying which central banks got how much, or what foreign currencies the Fed was and is still holding.

Where did those returning dollars go? My guess is they went to agency bonds and agency-backed MBS, thus preventing the decrease in the accommodative balance sheet. It could have gone to Treasuries to support the auction.

The dollar decline coincides very well with the stock market advance since March low. In fact, right after a sizeable chunk (over $50 billion) of dollars came back, the stock market bottomed and started the furious ascent as U.S. dollar cratered (the left-most arrow in the chart).

For fun, here's another set of charts - the top is the above DXY-Fed swap chart, vertically flipped, and the bottom is S&P 500 index.

Where is the Federal Reserve buying those agency bonds and MBS from? They are not saying. It's a trade secret. Again, my wild guess is from foreign central banks and U.S. financial institutions who get to dump them on the Fed at face value. (Well, that's how the Fed accounts for them, at face value.)

In the beginning of March, the foreign currency swap balance on the Fed's balance sheet was $375 billion. In the October 8th balance sheet, it was down to $50 billion, with about $7 billion U.S. dollar swapped back. That's a significant size for the past 2 months, and sure enough, U.S. dollar resumed the descent.

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