Trying to pour liquidity into a frozen market

YESTERDAY’S coordinated central bank move flipped the FX markets onto their head, with increased dollar liquidity triggering a sell-off of the greenback, with the euro and the Aussie and Kiwi dollars coming out on top.

The announcement came hot on the heals of the news that the People’s Bank of China, the country’s central bank, announced that it was lowering its reserve requirement ratio for the first time since the 2008 crisis. The 50 basis point revision is aimed at restoring liquidity to the Chinese banking system on the back of easing inflation. The Chinese policy triggered a risk-off move in the Asian trade, with the dollar climbing against the majors. But the Fed-led coordinated central bank move reversed this trend.

The Federal Reserve, the European Central Bank, Bank of England, Swiss National Bank and the Bank of Canada all intervened to lower US dollar liquidity swap rates by 50 basis points – so the new rate will be the US dollar overnight index swap (OIS) rate plus 50 basis points.

Yesterday’s move by the central banks is designed to make it cheaper for institutions to borrow in dollars from the central banks – decreasing the price of interbank borrowing and so increasing banking sector liquidity. When the move was announced at midday yesterday, the Fed stated that the new pricing would be applied to all operations conducted from 5 December and that the authorisation of these swap arrangements had been extended to 1 February 2013. The central banks involved in the move have also agreed to establish bilateral liquidity swap arrangements so that liquidity can be provided in any of their currencies should it be required, with these swap lines also in place until 1 February 2013.

The move was reminiscent of 2008 interventions when the interbank market went into deep freeze, leaving banks struggling to maintain short-term liquidity requirements. But while yesterday’s move will help to ease dollar liquidity issues, it does nothing to ease the funding problems caused by the European sovereign debt crisis. The move was also a tacit announcement to the markets at large that, under the surface, things are even worse than they seem. As Percival Stanion, head of asset allocation at Barings, points out, yesterday’s move was just another stop-gap measure: “There seems to be little understanding on the part of the establishment that secondary market prices for government debt are the starting point for private sector cost of credit.” Percival adds: “Banks can be kept alive on unlimited supplies of cheap liquidity from central banks, but ultimately if their cost of funds is too high their businesses are essentially in run-off.”

SHORT-TERM SOLUTIONS
In recent months, the dollar has strengthened due to its safe haven draw during the European sovereign debt crisis. But with the injection of dollar liquidity into the market, we saw heavy dollar selling out of short euro-dollar positions, as well as a drive into risk correlated assets. However, this should not be seen as a long-term trend reversal. “With the cards on the table now, the rotation of funds into riskier investments is unlikely to be sustained beyond a few days; this isn’t the start to a bull rally,” says Chris Vecchio, currency analyst at FXCM. “The problem with the Eurozone and the global financial system at the moment is not liquidity; it is solvency. If sovereigns are unable to lower their borrowing costs, it will not matter how much liquidity is pumped into the system”

The cheery message that can be taken from yesterday’s coordinated central bank move is that, no matter how bad things may seem, they’re going to get much worse.