Fed’s Currency Swap Lines: A BIG deal for the Dollar

By Bryan Rich, MoneyandMarkets.com

The Fed met this week on monetary policy. It was a bit of a snoozer. What wasn’t a snoozer, however, was what they’ve included in their recent monetary policy statements regarding currencies.

Most market participants have been entranced by the Fed’s language about their target interest rates …

Will they say they’ll keep rates low for an “extended period” or not?

But the real story was buried in the last paragraph of the December Fed statement and reiterated in their latest statement.

Here’s what it said …

“The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1.”

Following the Fed’s statement this week, there was a coordinated release of comments from the European Central Bank, the Bank of England and the Swiss National Bank confirming that the swap lines were no longer needed.

For the currency markets, this is a big deal. Yet, few have thought the juicy details of the Fed’s plans on currency swaps are of interest.

But I do. I suspected it was a game changer for the dollar when I was studying the statement last December. And so far, the price action in the currency markets is confirming that.

Here’s a bit of background …

In September and October of 2008, the Fed announced that it would be opening temporary currency swap lines with central banks around the world in fixed amounts through April of 2009. As that expiry date neared, the Fed extended the period to October, and then extended it again until February of this year.

Here’s what that means: The Fed agreed to give foreign central banks U.S. dollars at a determined exchange rate for the currency of the respective foreign counterpart. And when the swap ends, the two central banks simply repay the same quantity of currency back. There’s no exchange rate risk and no impact on the demand for currency in the open market.

Why Did the Fed Offer Dollars to the Rest of the World?

When the credit crisis was at its peak, banks around the world were hesitant to do any short-term lending with other banks. As a result foreign bank-to-bank lending rates for dollars, the world’s primary business currency, shot up. That restricted access to dollar borrowing and pushed a lot of consumer interest rates higher in the U.S. and abroad.

By providing these currency swaps with other central banks, the Fed helped to inject dollar liquidity into banks around the world. And it was well needed.

In short, it was good for the global financial system because it helped reduce the fear premium that was causing market interest rates to soar.

You can see this clearly in the chart below. In panel A, while the Fed and other central banks were cutting benchmark interest rates to the bone (the white line), the Libor rate (the orange line), or the rates at which banks make short term loans between themselves, was going in the opposite direction.

Panel A and B

Subsequently, when the dollar swap lines were rolled out, you can see in panel B how this divergence was reversed.

The Implication for Currencies

Most importantly for currencies, what these currency swaps did was increase the supply of U.S. dollars in the global markets — a negative drag on the value of the dollar.

So with the Fed announcing that it will close its currency swap lines with foreign central banks by February 1, the unlimited access to dollars by foreign central banks has come to an end.

This development is easily a positive for the dollar.

Let’s take a look at the timeline of these developments and the respective performance of the dollar …

U.S. Dollar Index

As you can see from the chart, following the Fed announcement that the swap lines would be extended through October, the dollar has gone through a period of decline. Since December, when the Fed announced these facilities would be ending in a little more than a month’s time, the dollar has been on the rise.

When they opened these massive swap lines in late 2008, the goal was to alleviate the dollar liquidity crunch at banks around the world. However, in the process they increased the supply of dollars around the globe — a negative consequence for the value of the dollar. But now that these lines will be closed, it’s clearly a dollar-positive development.

And with the weight of evidence leaning in favor of the dollar at this stage, as I laid out here in my article last week, this latest announcement by the Fed provides more reason to believe in this dollar rally.

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