[Roccland]

Starving for Dollars

We turn to Europe in this commentary as important events are occurring there behind the scenes and Asia has gotten the lion's share of the attention recently. The mariner's distress call actually comes from French, where "m'aidez" simply means "help me." We thought that would be a particularly appropriate title as Europe's financial system is starting to show signs of severe distress. From the actions of the CBs over there, we can infer that the problems there may be significantly worse than here in the US. Current open market operations show that the ECB has 451 billion Euros (about $640 billion) outstanding. This dwarfs the Fed total of just over $300 billion - including all liquidity facilities. It's pretty clear that there are many European banks in deep, deep trouble.

Starving for Dollars
It is also becoming increasingly clear that the European financial system has a desperate shortage of dollars. Since much of the debt outstanding is denominated in dollars and many European banks have taken in dollar deposits as well, there is a need for them to transact in our currency that is not reciprocated. When the Fed and foreign CBs set up the currency swaps, there was some suggestion that the purpose was to give the Fed enough Euros to intervene in the currency markets. That really didn't make much sense as the Treasury and the Fed have conducted a sub rosa weak-dollar policy for years. The logical and obvious explanation is now coming to the fore - Europe is seriously short of dollars and if they were forced to go out into the market and buy dollars, our currency would strengthen too much for the planners at the Fed who have been attempting to devalue it.

The bid to cover ratios from recent auctions make the point quite forcefully. The last set of TAF auctions in the US produced ratios of 1.51 and 2.19 (for the initial 84-day facility). The comparable ECB auctions in Euros had a bid to cover of 1.58. But ECB dollar auctions were bid at 4.56 and 3.85. US banks' demand for dollars appears to be roughly equal to Eurozone banks' demand for Euros. But Eurozone demand for dollars is twice as great as either one. This trend is confirmed by the result of the Swiss dollar auctions. Those had bid to cover ratios of 2.90 and 4.90. Finally, note that the Fed is not auctioning off Euros or Swiss Francs to anxious American bankers.

In addition, the high-yield bond market in Europe is completely frozen. Not one junk issue of any size has come out of Europe this year or for quite a few months of 2007. Retail sales there are falling farther and faster than in the US and the housing bust there has barely begun. Granted that theoretically the ECB had more room to cut rates than the Fed but the strength of unions and the social program costs make a wage-price spiral much more likely in the Eurozone, which seems to be constraining the actions of the ECB.

Quote from 1930s:
'We don't really know what happened, we only know that suddenly, there just wasn't enough money.' - Unknown

[efarmer]

Our dollars are still cooked in oil, but we are now using much less, and a far more premium oil when we cook our currency. This makes a very light and crispy dollar as compared to what we used to serve. Yes that's right, our Euro patrons can now eat as many of our dollars as they wish, and still not suffer that full and bloated feeling.
If you are one of our UK patrons, you can dine with confidence that while you are feasting on our dollars, the Pounds are melting away. If you enjoy Welsh Rabbit, be sure to ask for our recipe to prepare the new Dollar Lite as a scrumptious Subprime Rib.

[Revi]

Maybe that's why the dollar is holding it's value lately. I was wondering why the price of things hasn't been climbing quite as fast as it was. I think we are into some kind of a deflationary depression now. Nobody has any money to do anything, so the price of things will now go down, but there is still the problem that nobody has any money.

I never knew that the europeans had so much money out there.

[SILENTTODD]

Interesting article. Something I wasn't aware of.

[Jack]

Very interesting indeed.

[essex]

Most interesting, thanks !

[zoidberg]

Why would the EU care so much about strengthening the dollar by buying dollars with Euros? Doesnt a stronger dollar strengthen exports to the US and solve this dollar shortage dilemma?

[MrBill]

It is really not much of a mystery. Fed funds is 2% p.a. while 3-month LIBOR is 2.81%, so the TED spread is 0.81%, which is significantly higher than it was last year when it was closer to 0.25% before the start of the credit crisis. But as a funding currency the US dollar is still much cheaper than the euro.

The ECB's reference rate is 4.0% p.a., but overnight funds in the interbank market are 5.25%, and 3-months Euribor is 4.956% or a full 0.95% over the ECB's target rate. That is very expensive. So European banks need US dollars to both service their US dollar obligations (like funding their US CDOs, etc.) as well as to fund commercial transactions.

If one is going to invest, say, in Russia, for example, one would want to borrow US dollars at L + 1.50% or 4.31% p.a. rather than borrow euros at E + 1.50% or 6.45% or a full 2% higher. So it is quite understandable why the demand for US dollars in Europe is high.

The cross currency swap between the Fed and the ECB (looking at it from the ECB's point of view) is a sell/buy of EUR/USD spot and a buy/sell of EUR/USD in the forward market. The spread or forward points would represent 'exactly' the interest rate differential* between the euro and the US dollar or the 2.146% p.a. between 3-mos LIBOR and 3-mos Euribor if the cross currency swap was for 3-mos duration. There is no arbitrage opportunity, although there is a spot FX effect* if the euro weakens against the US dollar during the duration of the swap. But to be honest I doubt the ECB really cares. They are doing this to stabilize the market and provide funding to banks and not to make money in the FX market.

*spot effect

sell 1 euro = $1.6000
buy 1 euro = $1.6000 +/- forward pts.
----------------------------
0 euro = 0 USD

sell 1 euro = $1.6000
buy 1 euro = $1.5000 +/- forward pts.
----------------------------
0 euro = $0.1000 +/- forward pts.

* interest rate differential

swap = [(depo rate ccy B x spot) - (depo rate ccy A x fwd rate)] x maturity
---------------------------------------------------------------------------
100 x 360

fwd rate = spot rate + [(depo rate ccy B - depo rate ccy A) x spot x maturity] / 100 x 360

UPDATE: ECB becomes dumping ground for unwanted ABSs

The UK's largest building society, Nationwide, said last week that it was planning to expand into Ireland to take advantage of "funding opportunities".

The building society will be able to access ECB funding by taking savings in euro from customers and establishing an operation within the euro zone.

ECB council member Yves Mersch said at a meeting of central bankers organised by the US Federal Reserve in Jackson Hole, Wyoming, that the bank had been discussing the use of central bank funding and had agreed on a "certain amount" of refinement to the existing rules. "At the margins there can still be cases where you see dangers of gaming the system," said Mr Mersch.

European financial institutions have been relying more heavily on ECB funding for liquidity needs as the crisis has driven up funding costs and lenders struggle to sell on securities (packages of debt).

The ECB has grown concerned that banks are taking advantage of its collateral rules, which are broader than those used by the US Federal Reserve and the Bank of England, and that they will become overly reliant on central bank money to fund themselves.

source: ECB lending to Irish financial institutions hits €44bn