Monday, October 13, 2008

The Central Banks' Dollar Bet

Today, the Central banks of the world took another unprecedented step in easing the credit crisis.

Money market rates eased on Monday after Europe's central banks said they would lend commercial banks as much U.S. dollar funding as they need.

In the latest joint bid to thaw frozen money markets the U.S. Federal Reserve, the European Central Bank, the Bank of England and the Swiss National Bank also scrapped their existing dollar auction systems and replaced them with a new fixed rate system.

"Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction," the Fed said in a statement.

"Central banks will continue to work together and are prepared to take whatever measures are necessary to provide sufficient liquidity in short-term funding markets." The Bank of Japan said it would also consider similar measures and the Fed said it would increase its currency swap lines with the ECB, SNB and BOE by an unspecified amount to fund the operations.


By putting the Dollar this much in play, several things will happen. First, it will obviously ease short term liquidity, and allow for more short term lending. Second, by dumping U.S. currency onto the market, it will put downward pressure on the Dollar. The Dollar has been strengthening lately but continues to be weak. A weak Dollar also becomes inflationary, because all commodities are priced in Dollars. Finally, such short term liquidity measures are almost always read as inflationary in general, and thus, they usually cause long term rates to go up. Last week, I pointed out that the previous aggressive and coordinated rate cuts by the Central banks wound up making long term rates shoot up. That's because such aggressive short term rate cuts are almost always seen as inflationary. I believe the same thing will happen now.

Mortgage rates have gone up nearly a point. Whereas at the beginning of the week, we were close to 5.5% on a traditional 30 year fixed, now it is back close to 6.5%. This was due almost entirely to the aggressive short term rate cuts that the Fed and its central bank partners orchestrated.

As such, what the central banks will likely wind up doing with all of these aggressive measures is create a system of haves and have nots. Those that need to borrow for short term, three months, one month, and even over night, will be able to get very attractive rates. We've seen that with the move in money market accounts. The rest of us that would need to borrow for the long term for things like car loans, student loans, and home loans, will see rates explode upward.

The so called market has applauded the latest move as we have seen equity markets explode upward in response to the news. Yet, that isn't the market to watch. The market to watch is the U.S. Treasury market which is closed due to Columbus Day. We saw the benchmark 10 year U.S. treasury give back almost one half of one percent in three days in response to the news that central banks were easing the short term rates. This latest news will likely be viewed with similar skepticism by that particular market. The 10 year U.S. treasury is the benchmark rate for most other long term rate. As such, what we will see is long term borrowing become much more difficult. Given that most so called experts agree that a stable housing market is crucial to the recovery, I believe the equity market's response to these latest moves is short sighted. These latest moves will likely cause the 30 year fixed mortgage to approach 7%. All that will do is drive away even more borrowers from real estate. I hope I am wrong, but as the world celebrates this latest move by the central banks, I see great danger on the horizon as a result.

No comments:

Post a Comment