Click here to read this article in pdf format: december-12-2011

By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.

How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.

But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BN taken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.

Let’s first begin by looking at what occurs if there is no intervention from the Fed:

As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, we live in a fiat currency world, and banks simply let their loans amortize. There’s no mark to market! With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.

Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.

In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30^th, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk.

As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.

Martin Sibileau