Today’s Federal Reserve Foreign Currency Swap Announcement: Worth The 491 Point DOW Surge?

by Michael Matheron · December 1, 2011

“I’ll gladly pay you Tuesday for a hamburger today”
– J. Wellington Wimpy (1932)

Today witnessed what is likely to be viewed in later days as a bout of “irrational exuberance,” primarily due to the “big Fed announcement” of currency swap arrangements with certain central banks, most notably the besieged European Central Bank (ECB). The ECB is indeed “central” to many increasingly loud cries by some to do something startling to resolve the crises in Italy, Spain, and, of course, Greece. European private banks in key nations like France and Italy are viewed as teetering on cracked capital foundations, so today’s Fed announcement is unsurprising. This morning, using statutory powers granted them by section 14 of the Federal Reserve Act (as amended), they . . .

“coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.” [full text]

The LIBOR-OIS rate is already near the zero bound,
the OIS rate itself is around .5%

In addition – and this got marketeers excited – the Fed agreed to drop the interest rate by 50 basis points (1/2 percent) that it charges against the central bank counter-parties for these swaps of dollars for euros, yen, pounds, and other currencies. That rate, however, is already quite low, so an extra half-point isn’t very likely to successfully end the European financial crisis, nor will it buoy the euro, actually quite the opposite. It does prove, though, that despite the gold bugs infesting the Republican party, our dollar, fiat as it is, is still the preferred world currency. Countries use dollar swaps to get rid of, for example, their own currency in order to meet obligations in U.S. dollars which exhausted euro-philes often prefer.

But actually, two other items were more surprising than this swap arrangement. Firstly, given the small – almost negligible – OIS+50 rate decrease from OIS+100, the equity market reaction was overdone, despite good U.S. economic data on jobs and production, and last week’s rip-roaring start to the holiday shopping season (pepper spraying aside). Yes, a rally simply based on U.S. economic data was in the cards, but much of that 491 point upsurge was based upon a likely faulty overreaction to, and misunderstanding of, the Fed’s currency swap announcement.

Secondly, these European crisis-related currency swaps are nothing new. The Fed’s done this many times before during the world’s present financial meltdown. See these:

Press release, September 18, 2008
Press release, April 6, 2009
Press release, May 9, 2010
Press release, December 21, 2010
Press release, June 29, 2011
Press release, November 30, 2011 (today’s announcement)

And then see the chart below of the Fed’s present currency swap positions.

Wanna Swap?

“Federal Reserve Foreign Exchange Swap Agreements

These swap facilities respond to the re-emergence of strains in short term funding markets in Europe. They are designed to improve liquidity conditions in global money markets and to minimize the risk that strains abroad could spread to U.S. markets, by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions.

Present Positions: U.S. Dollar Liquidity Swap Operations (USD mn)

11/16/11

Operations during week ending 11/23/11

11/23/11

Outstanding (A)

Matured (B)

Drawn (C)

Terms*

Outstanding
(A-B+C)

Bank of Canada

N/A

Bank of England

N/A

Bank of Japan

N/A

100

N/A

100

European Central Bank

500

552

8-Day, 1.08%

552

1,748

N/A

1,748

Swiss National Bank

Total

2,349

501

552

N/A

2,400

^A	Total value of swaps that have settled, but have not yet matured as of, and including, the date at the top of the column.
^B	Total value of swaps that were unwound during the week. The “week” begins on the business day immediately following the date referenced in A through the week ending date.
^C	Refers to the total value of swaps which have settled during the week, but have not yet matured.
^*	Annualized interest rate of the transaction. Only includes terms for transactions referred to in “C”.”