Why the Swap Cut Rally Will Likely Be Short Lived

Why the Swap Cut Rally Will Likely Be Short Lived

The Federal Reserve and the ECB, together with 4 other central banks, decided to lower rates on dollar swaps by 50 basis points. As mentioned in recent days, the euro/dollar swap has reached levels last seen in 2008.

This coordinated action had a strong impact on currencies, and sent EUR/USD back to the range seen last week. This range lasted until the failed German bond auction. How long will this rally last? Looking at the last central bank cooperation, the answer is: not too much. The ECB hasn’t used its real ammunition yet.

The positive news is that 6 central banks can cooperate when the going gets tough. In the statement released by the Federal Reserve, we learn that further measures are prepared, if needed.

The bad news is that the situation deteriorated so badly, that such a wide coordinated move was needed. This is not enough: not from central banks and not from governments.

Temporary Patch for Banks

European banks have been struggling for months with funding in dollars. Some needed the ECB. The banks are looking to sell assets and squeeze down. The Franco-Belgian bank Dexia was split. Euro/dollar swaps reached record negative levels last seen in 2008.

So, this step will definitely help the banks, at least for the short run, and avert a quick and dangerous collapse.

This is not the first coordinated move by central banks seen this year. The  Fed already provided liquidity    to the ECB, also in coordination with other central banks. That was in September, only two months ago. That move also lifted the markets, but was short lived as more bad news rushed in.

This doesn’t solve the root of the problem

The problem is that debt is too high and also too expensive to maintain. Greece’s debt is too high at any yield levels. Perhaps Italy could have continued rolling on its debt if yields remained low. But they’re not low and confidence is lost for a long time.

Since that decision in September, numerous summits at the European level and the global level were held. The ECB has slightly accelerated its bond buying.

But the situation worsened: after stabilizing in August, Italy’s yields made another move higher and reached dangerous levels, despite the replacement of the government. In addition, the bond rout spread also to France, and followed through to solid countries such as Austria, Finland and the Netherlands.

And last week, Germany also failed to cover a bond auction.

Summits and Plunges

Another EU Summit is set for December 9th. The last summit discussed leveraging the EFSF bailout fund, but it became apparent that this ins’t possible at the moment.

Having one failed conference after another means that each rally that follows is smaller and shorter than the one seen after the previous summit. The falls that follow are sharper.

Tapping the Resource

What is needed is the unlimited amount of money that the ECB can supply. The ECB isn’t ready to tap this resource and isn’t ready to print money. Why? The main reason is that this will encourage irresponsible policy by governments, and can also ignite inflation. In addition, there is also a legal limit of not monetizing debt, but the ECB is already doing it.

There is a possible solution in the works: the ECB will lend money to the IMF, which in turn will buy Italian debt. If this implemented in a large scale, it can stabilize the situation, but still be QE, that will weaken the euro.

This will likely be followed by more measures by the Italian government and it will not be called an official bailout. So, officially the ECB will not buy Italian bonds en masse, and Italy will not be officially bailed out, but that’s exactly what will happen.

Until then, the swap cut rally can survive the week, but isn’t likely to pull through to the next one.

Further reading: Cracks in ECB Sterilization – QE One Step Closer

Yohay Elam

Yohay Elam

Yohay Elam: Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I've accumulated. After taking a short course about forex. Like many forex traders, I've earned a significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I've worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.