I hope everyone had a safe and Happy Thanksgiving, and that you have finally recovered from all the food! I’m sending this week’s market commentary from sunny Orlando. I was asked by the CFP Board to serve as a Subject Matter Expert to assist in determining the cut score for the upcoming CFP exam in the spring. Don’t worry – I’m still monitoring the markets each day, and will be returning to the office Wednesday.
Global markets were off to the races last week on the fact that global central banks had to come to the rescue of global liquidity drying up, and the possibility of bank failures in Europe. Surely, this is not the kind of news that will spur a meaningful, sustained rally in stocks; quite the contrary actually. We must not forget that liquidity problems of the magnitude we are seeing in Europe led to the 2008-2009 market rout.
Nothing to See Here
We have all seen a police show where a bad accident or murder has just taken place, and a police line is set up with an officer telling everyone to “move along; there is nothing to see here.” In reality, there is plenty to see even for those that want to peek through the fingers covering their eyes. I am not sure if most Americans realize that this past week we saw an epic version of the hustle along. We were all told the all-too-familiar lie about nothing to see this past week by none other than the super-secret Federal Reserve. In case you missed it, all of the largest global central banks announced the lowering of their US dollar to swap interest rates in a coordinated fashion. Keep in mind these swap lines have been opened since 2007; this was not new. What was new was the lowering of the interest rate.
According to the Fed, here’s the definition of a dollar liquidity swap:
When a foreign central bank draws on its dollar liquidity swap line with the Federal Reserve, the foreign central bank sells a specified amount of its currency to the Federal Reserve in exchange for dollars at the prevailing market exchange rate. At the same time, the Federal Reserve and the foreign central bank enter into an agreement for a second transaction that obligates the foreign central bank to buy back its currency on a specified future date, which could be the next day or as much as three months later, at the same exchange rate used in the initial leg of the transaction. Because both legs of the transaction are conducted at the same exchange rate, the recorded value of the foreign currency amount is not affected by changes in the market exchange rate, and the Federal Reserve bears no exchange rate risk. At the conclusion of the second leg of the transaction, the foreign central bank pays interest (which is what was lowered this past week) to the Federal Reserve on the dollars drawn.
THIS HELPS FOREIGN BANKS!
In addition, the Fed also reopened the foreign currency liquidity swap lines. These were closed back in 2010, but were reopened this past week. You can imagine this as the reverse of the above in that it provides US banks with the ability to exchange US dollars for foreign currencies should they need it. I think we all know that our banks are not in good shape, but the European banks are nothing short of an absolute disaster and in desperate need of US dollars.
Bottom line here is that this kind of financial pump priming only happens when banks will not lend to each other and results in banks that are strapped for cash in one form or another.
Now the disingenuous part
According to the Chicago Tribune:
A top Federal Reserve official said on Wednesday that a decision to alter the terms of dollar swap lines with foreign central banks was meant to help economic growth, not bail out Europe.
“We are not bailing out … Europe,” Dallas Federal Reserve Bank President Richard Fisher said in an interview with Fox Business Network. “We are trying to meet a shortage of dollars.”
What Mr. Fisher (above) said was we are not bailing out Europe; we are trying to bail out Europe. Meeting a shortage of dollars is bailing out not just Europe, but European banks. The reason for this is that European banks are having a hard time getting their hands on US dollars because no bank wants to lend to the others. In addition, European banks are desperate for US dollars since many transactions are settled in US dollars. This swap business was about protecting European and US banks from losses which are being brought on by dangerously leveraged, chained together derivative trades that put all of the big, global banks in bed together. The dollar swap lines give foreign central banks the ability to borrow dollars against their currency, use them for whatever they want (like to shore up bets made by European banks that went wrong) and at a later date, return them.
So, in fact there is plenty to see here. What I find curious is the timing of the recent action. We all know that the last few months have seen some enormous strains on global markets, economies and banks. Why now, and not at any point over the last few months? If I had to bet on a reason, it is because not only was a large European bank about to bite the dust, but the recent credit downgrades of just about every major US bank hit Goldman Sachs very hard. You see – a credit downgrade increases borrowing costs such as interest on debts owed. Goldman Sachs’ liabilities are not backed up by a big asset pool, and therefore, are very sensitive to interest rate movements. The Goldman credit downgrade made the Fed stop and say we could have another Lehman Brothers.
Very few people know for sure why this past week was the point for this intervention. But, there have been some clues as to what is happening out there (i.e., MF Globals’ leverage collapse, Dexia Bank’s collapse, and a few other more complicated indicators). These clues point to the fact that the necessary liquidity to drive the financial markets is drying up fast.
So in light of all this, what is an investor to do? Put simply, don’t overreact and continue to look for sustainable improvement in the global economies – one day of 4% returns doesn’t mean the world is fixed all of a sudden. While the markets can be scary these days, I’m confident that my nimble strategy will hold as we navigate these tough times.
Do you have an investment strategy that seeks to protect your portfolio against volatile economic conditions? Call me to schedule a free review of your current investment portfolio – 913.693.7918.
John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit https://www.chladekwealth.com.
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