Could Santa’s Sack Be Filled With Coal?

Conclusion: Don’t get too excited by the centrally-planned easing of financial conditions this morning. History suggests, if anything, they are likely to be a precursor to deteriorating economic data and financial market conditions.


It is not a secret that our intermediate term outlook for the global economy is somewhat dour based on an outlook of tepid economic growth and sticky inflation. The question now, of course, is whether today’s coordinated policy actions should change that. For our thesis to change, today’s action would have to change the outlook for either inflation or growth.


For starters, with consensus focused squarely on the central planning of central bankers in hopes that it will ignite the year-end Santa Claus rally, we thought it might be value-add to offer some contextual analysis around what just happened.


Per the Federal Reserve’s monetary policy press release from today:


“The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing 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… These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.”


This sounds vaguely familiar to their September 18, 2008 press release:


“Today, the Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing coordinated measures designed to address the continued elevated pressures in U.S. dollar short-term funding markets. These measures, together with other actions taken in the last few days by individual central banks, are designed to improve the liquidity conditions in global financial markets. The central banks continue to work together closely and will take appropriate steps to address the ongoing pressures… The Federal Open Market Committee has authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks… All of these reciprocal currency arrangements have been authorized through January 30, 2009.”


Appropriately based on this policy action, and as highlighted in the chart below, the Fed Dollar liquidity swap line rate has adjusted from 1.1% to 0.6% in short order, which will allow cheaper access to U.S. dollars for the cash-strapped European banks. Ironically, the noteworthy takeaway here is that assuming a constant U.S. dollar OIS rate and flat discount rate of .75%, when the Fed’s new measures kick in on December 5th it will be roughly 15 basis points cheaper for European banks to borrow U.S. dollars from the ECB than for U.S. banks to get them from the Fed. 


Could Santa’s Sack Be Filled With Coal? - 6


Equity Market Context

Accepting the fact that this is 2011 and NOT 2008 (an assertion we’ve maintained throughout the year), looking at a chart of the “market reaction” to the 2008 action, we saw the S&P 500 rip +98.7 points (or +8.5%) higher in a span of just two days.


Could Santa’s Sack Be Filled With Coal? - 1


The “market”, of course, went on to fall -578.55 points (or -46.1%) from the centrally-planned lower-high to economic reality nearly six months later.


Could Santa’s Sack Be Filled With Coal? - 2


As it relates to today’s market action, the SP500 ended the day up +51 points. Interestingly, the commodity markets are showing little of the return to risk on as WTI oil is only up 0.70% and the CRB index, more broadly, is only  up +1.09%. So, interestingly while there is clear shift into equities, we are not seeing the same follow through into commodities, which would imply that the outlook for economic growth has not been altered meaningfully as a function of this concerted policy action.


Credit, Funding, and FX Market Context

In terms of the credit markets, the reaction also seems to be somewhat tepid. The yield on the Italian 5-year bond, a good proxy for the European sovereign debt issues, closed at 7.5%, which was down only marginally on the day by -13bps and still at, or near, its all-time highs. As well, both LIBOR and Euribor have not moved meaningfully. In fact, the LIBOR 3-month spread is at 43bps and the Euribor 3-month spread is at 99bps, both of which remain at highs for the year. Finally, the Euro, which touched 1.355 intraday today, is now near its lows of the day as highlighted in the chart below.


Could Santa’s Sack Be Filled With Coal? - 4


A stealth takeaway in amid all the hysteria could be that the EUR/USD exchange rate is potentially allowed to trend lower at an accelerating rate. There has been speculation by many market participants that the rate has been artificially supported by the repatriation of European banks’ forced US dollar-denominated asset sales amid a drying up of USD-liquidity. Presuming that they can soon borrow US dollars at a very attractive rate from the ECB starting on December 5th, we would expect to see less repatriation on the margin from European banks. Ironically, the centrally-planned assault on investor hedges might actually be the catalyst for systemic correlation risk if the EUR/USD no longer has the support of cross-border repatriation.


From our vantage point, while this recent round of action does, on the margin, ward off imminent liquidity concerns for ailing European banks, it does nothing to address the solvency issues created by the marked-to-market value of their sovereign debt exposure – arguably the primary risk facing the global financial system today. Nor does it materially impact the looming specter of slowing global growth.


Moreover, presumably our central planners aren’t taking such drastic measures because they think “earnings are fine”. Perhaps their access to and analysis of exclusive interbanking data suggests to them that such aggressive measures are needed (yes, we think reducing the cost for insolvent European bankers to obtain access to our currency is an “aggressive” measure). They and the Chinese saw the need to attempt to ward off further deterioration in financial/capital market conditions in early September of 2008 and that was actually appropriate foresight.


Daryl G. Jones

Director of Research


Darius Dale


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