Central bank bazooka misses the mark

Euphoria spread across the market as investors reasoned that by easing a channel of sourcing dollar liquidity, it reduced the incentive for institutions in Europe to liquidate positions to buy dollars. However, doubts remained whether central banks were doing anything other than papering over the cracks of the financial crisis, after they agreed to lower the pricing on the existing temporary dollar liquidity swap arrangements by 50 basis points, so that the new rate will be the dollar OIS rate plus 50bp.

Indeed, price action in EURUSD cross currency basis swaps, the key gauge of funding stress, indicated that relief was fleeting, with the market still showing elevated levels of tension.

“It helps but I don’t think it’s a game changer,” says Adam Cole, global head of FX strategy at RBC Capital Markets. “It eases pressure on banks to some extent but it doesn’t deal with the root of the underlying stress in the financial system.”

Maurice Pomery, chief executive at Strategic Alpha, concurs, although warns that standing in front of the initial risk rally is “suicidal”.

Pomery said while the drying up of dollar funding was posing a risk to the financial system, larger issues remained unaddressed.

“The big issue is not one of liquidity as it is more about insolvency and that requires quite a different set of action,” he says. “The Fed et al have easily helped an ailing funding market but the bigger problem of sovereign solvency remains.”

The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve and the Swiss National Bank announced coordinated action to enhance their capacity to provide liquidity support to the financial system. The facility applies from December 5 until February 2013. In addition, the BoE, the BoJ, the ECB and the SNB will continue to offer three-month tenders until further notice.

They added that as a contingency measure, they had also agreed to establish temporary bilateral swap agreements, so that liquidity could be provided in each jurisdiction, in any of their currencies, should market conditions so warrant.

Spot reaction:

The dollar, which had come under pressure earlier in the session after China announced the first easing of its monetary policy of three years, plunged lower.

EURUSD, which had been hovering just below $1.33 ahead of the announcement, rocketed 200 pips higher to stand above $1.35. GBPUSD, which had been struggling to hold above $1.56, jumped more than the big figure to stand above $1.57, while the risk sensitive AUDUSD rose to 1.03, having stood just above parity before the announcement.

However, traders said volume in the spot market was relatively light, with one chief dealer at a top-three bank saying the reaction had been dominated by stop loss activity and order book management, rather than any real underlying customer flow.

Forwards/basis:

In the forwards market, where bank demand for dollar funding had been sending prices to extreme levels, tensions initially eased. The move was fleeting however, with EURUSD cross currency basis swaps re-widening.

The benchmark three-month EURUSD cross currency basis swap initially narrowed by 40bp to -120bp, pulling back from -162bp before the announcement, its widest level since the immediate aftermath of the collapse of Lehman Brothers. It has since widened out again to -138, with the three-month swap trading in a range of +7 to +23bp, and was at +16 at 10am New York time on Wednesday.

One head of forwards trading at a UK bank said the move would remove the stigma from using the central bank funding window – until now, it has been used sparingly, as banks have been terrified of it getting out that they have been taking the funds.

“By making it incredibly attractive, hopefully it will remove the stigma, which means banks are more likely to use it rather than retreat into the FX swap market, so the basis should ease,” says the trader.

The three-month EURUSD cross currency basis tightened from -60bp to -120bp and has now moved back to around -140bp. The three-month swap has had a range of +7 to +23bp, now +16. These are huge moves given the volumes traded.

Options:

Predictably, option vols were softer on the announcement. One option trader said there’s potential for one-year EURUSD to come off a lot, though it’s still holding above 16 currently – although offers are beginning to appear, but in light volumes, says another chief options trader at a European bank. Front-end vols still remain well supported for the gamma.

“One-year squeezed higher on good demand in the past few weeks, so has the scope to come off a bit if, again, spot consolidates higher,” says the trader.

“Furthermore, one-month realised before this move were was approximately 12.8%, indicating that there’s a load of risk premium built into implieds, and thus it feels that EURUSD options are very expensive to hold if the currency trades around the mid 1.3000s for a while.”