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Minyan Mailbag: Europe Propping Up the Dollar?


Fed intervention under a different name.

Inquiring minds are pondering the question "Is the European Central Bank (ECB) propping up the U.S. dollar?"

Please consider the following e-mail chain over the past five days, all from people whose opinions I respect. The discussion started with an email from Minyan Philip on May 2nd.

Minyan Phillip: Mish, I've gotten a few "runarounds" when I've questioned others about the news that the Federal Reserve and the ECB put a swap in place for $36 billion to supposedly reduce the cost of LIBOR. My personal opinion is that it's a "carry trade" transaction that is designed to limit the impact on the dollar. By borrowing at the overnight rate in the U.S., Euro banks can reduce their need for LIBOR while getting cheaper rates, but this would lead to a short on the dollar, which would be hugely negative for the Euros.

It seems to me that this swap allows for the carry trade without impacting the value of the euro, and if demand for dollars is limited, it allows the Fed to buy euros and settle in euros, thus increasing the value of the euro versus the dollar. Basically, we get intervention while calling it a different name. Any thoughts? Thank you.

Mish: Phillip, I posed your question to a friend of mine, "HB," who lives in Europe and whose opinion I highly regard. This is what he had to say:

HB: As far as I'm aware, these swaps tend to occur to alleviate temporary 'dollar shortages' in the European interbank payment system. There are a great many 'eurodollars' floating about and various claims relating to them. Since the European banks don't trust each other anymore, there are frequent episodes of LIBOR shooting higher and temporary dollar shortages. So yes, this is intervention aimed at bringing down LIBOR and allowing Euro-zone banks easy access to dollars. Every time the dollar has gone up in recent months it was due to similar developments, in my opinion.

Phillip: Thank you for that answer. Adding on to HB's excellent explanation, I did a little further digging myself. I broke out my international financial markets textbook and I think I've got it. By putting a floor under the exchange rate, the implied interest rate comes down – in this case euro LIBOR because an arb opportunity would exist if euro LIBOR remained at current levels. What we don't know is the implied forward rate in the Fed/ECB swap agreement but we can surmise that it's below prevailing forward rates because to do otherwise would make it a useless transaction. Since there's a 2% interest rate differential between the two overnight rates, if we assume that the swap agreement has an implied forward rate that is the same as current exchange rates between the two banks, this would suggest that the ECB is paying the Fed 2% to put a floor under the dollar. Interesting stuff!

My instincts are telling me that this is a currency support baked in the explanation of trying to bring LIBOR rates down because the law of one price tells us that they are one and the same. I don't doubt any part of the official explanation but I'm essentially questioning whether there is more to the story. In addition, I'm highly skeptical of Paulson's desire to strengthen the dollar.

However, I don't believe a $36 billion swap is enough of a threat at the present time.

Mish: Let me follow up on that last point with Minyanville professors Boris Schlossberg and Kathy Lien at DailyFX.

Prof. Schlossberg: Mish, Kathy and I are both on the road today, but my initial read of the situation is that this is a minor story in determining FX flows which are predominantly driven by speculative demand rather than physical settlements. Any arb that may exist is not significant. $36 billion is chump change in a market that turns over 3 trillion daily.

HB: Yes, it's chump change in terms of the forex market, but at the margin it is probably still an influential sum, because the swaps remove upward pressure on the dollar created by European bank demand. Essentially, they need to borrow in dollars vs. dollar denominated assets, and it seems many of their dollar assets are difficult to use as collateral in the interbank market in Europe at the moment, as every bank wants the same (namely cash and liquidity). So now they can go and get their dollars from the ECB, which presumably accepts dollar denominated collateral in exchange for dollars.

Mish: To wrap up, I do not think we have a definitive conclusion here. I wish I could report otherwise. If nothing else, the above email chain poses an idea of how intervention might be attempted to be carried out under guise of solving a liquidity problem elsewhere.

Furthermore, and this is important, please remember that, in my opinion, Chairman Ben Bernanke and the Fed are willing to try just about anything. A plethora of lending facilities is proof enough. It pays to consider all angles, even if some of them are inconclusive.

By bringing this discussion to light, we have something to watch for down the road, should these kind of swaps increase at an unusual pace.
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