Many have been left in a profound state of confusion over the Federal Reserve's recent interest rate cut of the dollar swap line.
As we have pointed out, these are not "swap lines", but are in actual fact dollar loans.
Firstly, however, it is important to recognize this interest rate cut as a very aggressive action on the part of the Federal Reserve against elements inside the European Central Bank (ECB). This is a clear sign that despite the phrase "internationally co-ordinated", it would appear to us that the relations between key departments at the ECB and the Fed are at an all-time low.
One of the reasons why the Federal Reserve decided to exert additional pressure unto the ECB is likely the result of the Fed itself coming under intense pressure from the Obama Administration to get the Europeans to print more money.
To understand this decision it is important to understand what exactly the Federal Reserve is saying.
They are saying to the Europeans to come and park your Euros here at the Fed in a special account, and in-exchange we at the Federal Reserve will give you the current exchange rate of dollars for that amount. You can spend those dollars anyway you want, but the Euros will be in this special account. All you have to do is pay this .1% interest rate on the dollar loan, and pay back the exact amount of dollars we give you now in three months time.
Now they have cut that rate from .1% to .05%.
So what is the Federal Reserve saying?
If we were a European bank, the only way we would park our Euros with the Federal Reserve (through the European Central Bank's facility -- a crucial element in understanding this story as the ECB has to embark on a mini-QE by default to make up for any losses that we estimate are to equal a net of $180 billion of ECB QE) and get back the equivalent of dollars that we have to return in three months, is if we believed that the Euro is about to drop. That is a good deal: Switch your Euros for dollars now, and then in three months time use those stronger dollars to buy back the equivalent amount of weaker Euros from the ECB.
The kicker is that Europe is presently experiencing a shortage of Euros -- the Germans are withholding the Euros from being printed, which the Southern Europeans have already paid for through a multi-trillion 30% lost in competitiveness to the Germans under the EMU regime.
So the Federal Reserve is saying to the Europeans: "Hey, friends, I know that people really need your Euros 'in the system' in Europe right now, but I am now going to make it that much cheaper (from .1% to .05%) for you to take those Euros out of Europe and move them into dollars. Oh, and by the way, we are going to do this at the height of panic about the Euro". The Federal Reserve is assisting in furthering the shortage of Euros in Europe. (Playing nice, are we?)
This also helps the balance sheet of the ECB (a perennial German concern), which indicates it is weaker than officially acknowledged.
This growing shortage of Euros (until the ECB prints) points to a stronger Euro relative to the Dollar, but even then (if the ECB does not print), the trade is unwound in three months time. (Topographic subscribers receive more insight on this EUR/USD point.)
By accelerating the intense shortage of Euros in Europe (and under a temporary duration), the Federal Reserve is both simultaneously (which makes this such a confusing topic) anteing-up the pressure on the ECB to print Euros, but also paradoxically temporarily strengthening the ECB (its balance sheet, that is).
The whole thing could backfire though. This has been the perennial problem with these so-called "dollar swap lines": The Euro could completely disappear in three months time (which gives lie to the sheer propaganda of the Fed that these Euros held in this special Fed account are a so-called "asset") -- those Euros parked inside the Federal Reserve's special account (through the European Central Bank) would become worthless, if the Euro disappears. It will effectively cost $0 for those Europeans who switched their Euros into Dollars to buy back their Euros at the Fed's ECB account. (Topographic subscribers receive more insight on this point.)
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Published Thu, 15 Dec 2011
What should be occurring is the European Central Bank (ECB) seeing the stated value of its around $80 billion in Greek government bonds cut in half to $40 billion, along with the Greek public banks seeing their Greek government bonds cut in half to around $20 billion officially. Other banks that own Greek government bonds are seeing the same thing, but not the ECB or Greek public banks. This Greek debt deal only affects about 20% of the Greek government's debtload, primarily because of the exclusion of the ECB from the haircut.
At any rate, these Greek government bonds are not really being chopped off by 50% (as reported) but more likely (once all the new maturities and interest rates are decided) by 30%-35%. This means the deflationary pull in Greece will not accelerate so much as a 50% haircut would have entailed.
We see the ECB not losing $20 billion as it should - even though many of the Greek bonds it has bought, were bought at 25% below face-value. In fact, the ECB is seeing its Greek government debt exposure getting strengthened as the market in these bonds is shrinking from this haircut.
The European Central Bank's balance sheet thus is likely to still have remaining on it: The $145-or-so billion that the ECB has loaned out to the Greek banking system already, and about $60 billion in real exposure (face value: $80 billion) to the Greek government bond market (bonds, which now have increased in value).
(Subscribers to The Topographic receive more analysis and data breakdown on the ECB's LTRO and its effects on the ECB's balance sheet as well as Euro/Dollar currency moves.)
Because these bonds have increased in value with this expanded haircut, the net result of this deal is Greek banks needing less loans from the ECB, so that paradoxically strengthens the ECB's balance sheet even more. (Notice a running theme here: strengthening the ECB?) We see the total ECB exposure to Greece at around (going off face value) $225 billion circa 2011.
However, another important point in this deal is that the new Greek government bonds set to be issued will not be fully financed through the Greek state, but through other European states too. So the European Central Bank's decision to keep on buying Greek government bonds is less risky as before, because these new Greek government bonds will have additional collateral (other European states) behind them. This means the $225 billion exposure the ECB currently has to Greece is likely to stall out around there.
Indeed, the new European Stability Fund is underwriting by 25% all the new government bond issuance from Spain, Italy, Portugal, Greece, Ireland, and (de facto) Belgium. This is financed by taking the $400-or-so billion in the Fund presently, and using that as collateral to issue bonds up to $1.4 trillion - with the buyers being China, India, Brazil, Japan, and the IMF which still has somewhere around $330 billion to deploy.
Furthermore, European banks are being required to raise an additional $200-or-so billion in capital (a deflationary pull that will achieve nothing, other than perfunctory coverage against a sole Greek default).
If we basically look into the future and see what this all means, we see this: The European Central Bank likely buying (more on the LTRO for The Topographic subscribers) $450 billion in Spanish, Italian, Portuguese, Greek, and Irish government bonds next year (2012) to keep financing costs for those governments low. That $450 billion will be insured by the European Stability Fund (25%) to the tune of approximately $125 billion.
Now, the fun part: The two biggest contributors to that $450 billion of the ECB's bond buying for 2012, will be Italy and Spain; and it is likely that around 25% of that $450 billion (or around $125 billion) will also constitute the total pile of government bonds purchased from Portugal, Greece, and Ireland by the ECB.
This $125 billion is equivalent to the insurance amount the new European Stability Fund will have issued on that $450 billion.
In other words, if Portugal, Greece, and Ireland all sink - the European Central Bank's balance sheet will still have $30 billion in assets from them, and have $95 billion in assets awaiting behind "the bond line" with Italy and Spain, all due to the insurance provided from the $1.4 trillion new European Stability Fund.
It is $125 billion in assets - negating (perhaps effectively) the $125 billion asset loss from a Greece, Portugal, and Ireland collapse in 2012.
This deal does, however, leaves open the question of what happens to all the bonds already purchased by the ECB from Ireland, Greece, and Portugal.
We can estimate the ECB's losses on Greece would be somewhere around $225 billion as of today, and can expect that for 2012 for that to stay around $225 billion (the dynamics point to it stalling out around that level). We also can reason that for Ireland and Portugal by the end of 2012, the ECB will own somewhere around a total of $120 billion in those countries' government's bonds. Furthermore, the ECB's exposure to Irish banks will probably be somewhere around $105 billion by then, and to Portuguese banks somewhere around $70 billion. Meaning if Ireland, Portugal, and Greece fall, then the losses the ECB will take, would come in somewhere around $500 billion ($530 billion minus $30 billion in insurance). The European banks themselves will likely take direct losses around $1.7 trillion.
If Spain and Italy (and their banks) can hold however, the ECB should be able to hold the line against such a $500 billion assault.
It is likely that the ECB will pay for the $500 billion hit by draining an additional $500 billion Euros from the European banking system - since the $500 billion is being moved out the "real economy" and into the bond market where investors typically "hold" the goods; we do rather see this as a dose of significant deflation. (This comes on-top of the ECB draining $270 billion due to the bond-buying purchases for the year at $450 billion, which is offset by the $125 billion in insurance issued on those bonds, and additional credits that probably ring in around $55 billion.)
As well, if Ireland, Greece, and Portugal do collapse for 2012, then the $1.4 trillion (minus the $30 billion loss) in the new European Stability Fund, can be redeployed to strengthen the underwriting protections on Spanish and Italian government bonds.
What is basically being done here is lowering the ECB's risk in 2012 on Ireland, Greece, Portugal, and effectively Belgium too; they are establishing a reserve for further protection; they are placing a bet on the solvency of Spain and Italy and their banks; they are fully embracing the risk of very significant deflation for Europe; and they are betting very strongly on France's solvency.
(More on LTRO risks for The Topographic subscribers.)
It is important to not see the $1.4 trillion of the new European Stability Fund as $1.4 trillion in new demand for Euros - this money is being held in the new European Stability Fund's bonds that will not be cashed into Euros unless a country whose bonds it is underwriting, defaults. It is acting as another floor on the Euro.
It is not a particularly strong floor, but it can afford to offer such mild protection because Europe is right now experiencing a deflationary tidal wave. This is not altogether unusual as most of Europe is aging, and deflation usually follows greying populations, but, it would seem that Europe is set to experience a $500 billion deflationary wave for 2012, which does not bode well for European stock markets. If Ireland, Portugal, and Greece collapse, then that deflationary wave will explode even further to around (we think) $850 billion and maybe beyond; to closer or even above $1.6 trillion in deflation, if the ECB has to start providing mass liquidity (and the concurrent draining) to the European banks affected by those three countries' collapse.
(The LTRO difference -- only for The Topographic subscribers.)
This "deal to save the Euro" comes closer to anything else seen to "containing" possible Irish, Portuguese, Greek, and Belgium defaults, but it destroys Europe. It certainly opens the range of the Euro-to-Dollar as somewhere around $1.50-to-$1.85, we reckon (minus the LTRO difference).
Published Wed, 7 Dec 2011
