December 3, 2011

Euro Credit Crisis: When 6 Central Banks Come To The Rescue

By Charles Rotblut

The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank agreed to lower the pricing on existing temporary U.S. dollar overnight swap arrangements. The intent is to provide liquidity to the global markets.

A currency swap is the exchange of one currency for another. For example, say a European company wants to hold $10 million in U.S. dollars and an American company has a need to hold euros. Using this morning’s exchange rate of 0.7431 euros per each U.S. dollar, the European company would send the U.S. company 7.431 million euros. In exchange, the U.S. company would send the European company $10 million in U.S. dollars. The interest rates are also swapped with the European company paying a U.S. interest rate on the dollars it received and the U.S. company paying an European interest rate on the euros it received.

So why is the U.S. Federal Reserve lowering the price on a currency swap program with the European Central Bank? The intent is to make the cost of lending cheaper, thereby helping economic growth. If European banks have easier access to low-cost funding, they should be more willing to lend money, which in turn helps the global economy. It was a tightening of credit that led to the 2008 downturn in the U.S.; the global central banks are now trying to prevent a repeat in Europe.

It’s not just Europe that could be impacted by a new credit crisis, however. Axel Merk, the president and chief investment officer of Merk Investments, explained to me this morning that European banks are the largest financers of Asian credit and many make U.S. dollar-denominated loans. As U.S. money market funds have cut back on buying debt from European banks, the cost of acquiring U.S. dollars has risen. In fact Merk observed, “What is shown in the market right now is that we are reaching the stress level in the lending market that we had in the fall of 2008.” As a result, the central banks felt the need to step in and take measures to encourage banks to lend.

The chart below from Merk Investments shows what is happening in the credit markets. As Axel explains, “The blue line is three-month (3m) euro basis swap rate. A negative value represents the premium that European banks are willing to pay to access U.S. dollar funding through the three-month swap market. The more negative the basis swap rate, the higher the premium that European banks are willing to pay and the higher the dollar funding costs are for European banks.

As depicted in the chart, the 3m euro basis swap rate hit -159 basis points (100 basis points are 1%) yesterday, showing that European banks were willing to pay an additional 159 basis points more than Libor (London interbank offered rate) to access dollar funding. After today’s announcement, the 3m euro basis swap drastically narrowed to around -130 basis ponts. That is, European banks are paying a lower premium to borrow dollars through the swap market.”

The action does not resolve the sovereign debt crisis, but as Merk notes, the problems are “interlinked.” Providing more liquidity keeps the banks afloat, which prevents a financial meltdown. This is why there was a big rally in the markets today; traders are more optimistic that the global central banks are working together to prevent a worst-case scenario.

Just keep in mind that there is still a cloud of uncertainty overshadowing the global financial markets, which means we may not be out of the woods yet. At same time, don’t wait for Mr. Market to give you the “all clear” signal, because he won’t give it until well after stocks have rallied.

The Week Ahead

Only four S&P 500 member companies will report earnings next week: AutoZone (AZO) and SAIC (SAI) on Tuesday and Costco (COST) and Pall (PLL) on Thursday.

The week’s first economic reports will be the November ISM services index and October factory orders, both of which will be published on Monday. Wednesday will feature October consumer credit. The preliminary University of Michigan December consumer confidence survey and October international trade data will be published on Friday.

Chicago Fed President Charles Evans will speak on Monday.

About The Author - Charles Rotblut, CFA is  the VP for American Association of Individual Investors Editor.  Charles is also the author of Better Good than Lucky.  EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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