Two days ago, in a surprisingly vocal announcement to make sure everyone heard it, the Fed extended the duration of its USD FX swap lines with foreign central banks from January (when they were due to expire) to August. One may ask: why the extension when Europe continues to lie that all is good, and when America has made it clear that it is not China, but the US, which will suddenly lead the next global growth spurt (ignore for a second that the recent jump in crude to just under $91 has wiped out virtually the entire benefit from the just passed payroll tax "stimulus"). One may also not get an answer. So while the announcement is nothing but the latest salvo in what is now merely a policy approach to risk asset pricing, the question of what is being achieved from a purely fundamental standpoint is likely somewhat relevant in our brave new centrally planned world. Bank of America provides the explanation to all those for whom the Fed's continuing backstop of Europe is a novel topic.
Extending the dollar swap lines
The Fed extended its dollar swap lines with a number of foreign central banks, including the ECB, to August 1, 2011. Recall that these swap lines - originally due to expire by the end of January - were put in place during the sovereign crisis earlier in the year to ease funding strains from a scarcity of US$ available abroad. Since the lines provide dollar funding through foreign central banks at a relatively fixed interest rate of currently about 120bps1, that effectively caps private market funding rates. After the US financial crisis where dollar swap lines were first put in place in reaction to an ongoing funding crisis, the Fed and foreign central banks reacted more proactively earlier this year before the sovereign crisis led to another funding crisis. Importantly, during the more recent resurgence of the sovereign crisis these swap lines remained in place and helped reduce from the outset market expectations of contagion through the founding markets. In reaction to the ongoing sovereign crisis today’s announcement extends this fire break for the funding markets well into next year.
How swap lines cap funding costs
During the credit crisis in 2008 the introduction of central bank dollar swap lines was a major contributing factor normalization of the dollar funding markets as seen in Figure 2 below. Basically the swap lines with the Fed allowed the ECB to meet dollar funding needs from European banks directly, alleviating funding pressures in the private market that led to rising LIBOR rates. While the original swap lines were allowed to expire, they were reinstated by the central banks back in May in response to the European sovereign crisis.
The second figure below (Figure 3) shows European private market funding in dollars constructed by borrowing euros at three-month Euribor and converting to dollars using a three-month EUR/USD basis swap. That compares with borrowing dollars directly from the ECB’s currency swap lines with the Fed at the penalty rate of OIS+100 bps. If private market funding (LIBOR-Basis Swap) was to become more expensive o European banks than the dollar swap lines provided through the ECB, these banks would find it more economical to use the swap lines. Thus the swap line penalty rate of 100+OIS effectively becomes a cap on LIBOR-Basis swap.
We see in Figure 3 below that the private market dollar funding cost (borrow Euribor, swap to dollar) has increased recently. This happened mainly due to funding pressures creating a dollar shortage as reflected in the EUR/USD basis swap.
To summarize: the Fed continues to do everything it can to transfer private balance sheet risk to that borne by the US taxpyer....in Europe, Switzerland, the UK, Japan and any other place that prints money.