Is The Fed Preparing To Lower The Rate On Dollar-Euro Swaps?
Yesterday we reported a rumor that the Fed and the ECB were set to announce "new liquidity measures." Today, the WSJ's Jon Hilsenrath reports that this development would likely materialize in the form of a lowering of the rate at which the Fed offers Euro-Dollar swaps, currently priced at 100 bps over OIS. This has not gone unnoticed by the market: even with 3M Libor flat from yesterday, the front month Eurodollar has surged from yesterday, on this most recent confirmation that the central banks will drown the world in free liquidity before another session of liquidations has to take place.
From the WSJ:
The Federal Reserve has a lever it can pull to help European officials combat a worsening financial crisis: Reducing the interest rate it charges on U.S. dollar loans it makes through the European Central Bank to dollar-starved commercial banks in Europe. The move, though not a cure-all, could relieve some of the strains in European money markets.
The loans currently are priced one percentage point above a market rate called Overnight Indexed Swaps (OIS), which tracks the expected path of the Fed's benchmark federal funds rate. The loans are set above OIS to discourage foreign banks from using the government program too aggressively. But the Fed could reduce that penalty to encourage more borrowing and ease some of the financial strain on foreign banks in need of dollars. Whether it chooses to take this step remains to be seen, and will depend in part on how markets behave in the days ahead.
Use of the Fed's central bank "swap" facility—launched during the 2008 financial crisis—reached $583 billion in December 2008. Since the Fed reintroduced it earlier this month, foreign banks have only tapped the Fed program for $9 billion, according to the most recent publicly available data. Fed officials will be watching the ECB's next big auction of dollar loans tomorrow closely for signs of whether demand is increasing.
Ironically, bidder participation in the BOE's dollar repo facility reopening two weeks ago was exactly nil, and rumors dominate that of the thousand or so banks in Europe, few wish to make their liquidity problems even partially known, which is why we anticipate tepid involvement in such ECB liquidity pass throughs. Hilsenrath shares the same perspective: "Some analysts say that adjusting the terms of the Fed's loan program
won't achieve much. "The funding is already available" through the Fed
program, says Bruce Kasman, chief economist with J.P. Morgan Chase. The
price, he says, is "expensive but not onerous."
The Fed has no concerns about being a willing participant with taxpayer capital into a program which could potentially lock up the next time there is a liquidity crunch:
Responding to audience questions following a speech in London, Federal Reserve Bank of St. Louis President James Bullard said the swap lines are "certainly not tapped out," and could provide much more funding if necessary. Mr. Bullard added that the far lower take-up indicates that dollar funding problems aren't as severe as in 2008-09.
"We can go much higher, hundreds of billions of dollars if necessary. We're not anywhere near that right now so I think it's sufficient and there is no limit on it," he said.
This swap program has been the Fed's main response to the financial stresses building in Europe. The market was abuzz with rumors Tuesday that the Fed could take some other step to help European banks—such as restart a commercial paper lending facility it used during the financial crisis or lowering the discount rate that it charges banks in the U.S. for emergency loans.
The only notable feature, as we have reported previously, is that should we get close to the half a trillion in total FX swaps we got to during the last peak, is that excess reserves will surge by a comparable amount. The risk is that with the Fed's balance sheet now entrenched in QE mode, adding emergency liquidity programs to it once again, will do nothing to alleviate inflation expectations, as all this extra liquidity will have to be unwound at some point. For the time being, the market still seems unconcerned about the form this tightening will take place. However, the level of concern is surely rising with every incremental dollar being piled on to the "asset" side of the balance sheet. Should we indeed have to follow through with another iteration of QE, with emergency liquidity measures layered on top, we could easily double the Fed's balance sheet within the year.