AAII Investor Update: Creating Liquidity for European Banks

Wednesday, November 30, 2011
Charles Rotblut, CFA
AAII Journal Editor

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Given this morning’s coordinated action by the major global central banks, I am sending out this week’s newsletter a day early. I am doing this to explain what the central banks did and why.

The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank agreed to lower the pricing on existing temporary U.S. dollar overnight swap arrangements. The intent is to provide liquidity to the global markets.

A currency swap is the exchange of one currency for another. For example, say a European company wants to hold $10 million in U.S. dollars and an American company has a need to hold euros. Using this morning’s exchange rate of 0.7431 euros per each U.S. dollar, the European company would send the U.S. company 7.431 million euros. In exchange, the U.S. company would send the European company $10 million in U.S. dollars. The interest rates are also swapped with the European company paying a U.S. interest rate on the dollars it received and the U.S. company paying an European interest rate on the euros it received.

So why is the U.S. Federal Reserve lowering the price on a currency swap program with the European Central Bank? The intent is to make the cost of lending cheaper, thereby helping economic growth. If European banks have easier access to low-cost funding, they should be more willing to lend money, which in turn helps the global economy. It was a tightening of credit that led to the 2008 downturn in the U.S.; the global central banks are now trying to prevent a repeat in Europe.

It’s not just Europe that could be impacted by a new credit crisis, however. Axel Merk, the president and chief investment officer of Merk Investments, explained to me this morning that European banks are the largest financers of Asian credit and many make U.S. dollar-denominated loans. As U.S. money market funds have cut back on buying debt from European banks, the cost of acquiring U.S. dollars has risen. In fact Merk observed, “What is shown in the market right now is that we are reaching the stress level in the lending market that we had in the fall of 2008.” As a result, the central banks felt the need to step in and take measures to encourage banks to lend.

The chart below from Merk Investments shows what is happening in the credit markets. As Axel explains, “The blue line is three-month (3m) euro basis swap rate. A negative value represents the premium that European banks are willing to pay to access U.S. dollar funding through the three-month swap market. The more negative the basis swap rate, the higher the premium that European banks are willing to pay and the higher the dollar funding costs are for European banks. As depicted in the chart, the 3m euro basis swap rate hit -159 basis points (100 basis points are 1%) yesterday, showing that European banks were willing to pay an additional 159 basis points more than Libor (London interbank offered rate) to access dollar funding. After today’s announcement, the 3m euro basis swap drastically narrowed to around -130 basis ponts. That is, European banks are paying a lower premium to borrow dollars through the swap market.”

(Click here for a larger image.)

Today’s action does not resolve the sovereign debt crisis, but as Merk notes, the problems are “interlinked.” Providing more liquidity keeps the banks afloat, which prevents a financial meltdown. This is why there was a big rally in the markets today; traders are more optimistic that the global central banks are working together to prevent a worst-case scenario.

Just keep in mind that there is still a cloud of uncertainty overshadowing the global financial markets, which means we may not be out of the woods yet. At same time, don’t wait for Mr. Market to give you the “all clear” signal, because he won’t give it until well after stocks have rallied.

Do you invest in currencies? Tell us on the AAII.com Discussion Boards.

Investing in Foreign Credit

Several mutual funds, and some exchange-traded funds, invest in foreign bonds. These bonds give you the exposure to higher-priced currencies and different interest rates than you would earn by investing in U.S. bond funds. These are not without risk, as the current situation in Europe has made apparent. Former AAII President John Markese explained the factors you should consider when investing in international bond funds in a 2008 AAII Journal article, “Rolling the Currency Dice: Investing in International Bond Funds.

The Week Ahead

Only four S&P 500 member companies will report earnings next week: AutoZone (AZO) and SAIC (SAI) on Tuesday and Costco (COST) and Pall (PLL) on Thursday.

The week’s first economic reports will be the November ISM services index and October factory orders, both of which will be published on Monday. Wednesday will feature October consumer credit. The preliminary University of Michigan December consumer confidence survey and October international trade data will be published on Friday.

Chicago Fed President Charles Evans will speak on Monday.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 33.0%, up 0.3 points
  Neutral: 27.5%, down 1.5 points
  Bearish: 39.4%, up 1.1 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment, expectations that stock prices will rise over the next six months, increased 0.3 percentage points to 33.0%. This is the second consecutive week that optimism has been below its historical average of 39%.

Neutral sentiment, expectations that stock prices will remain essentially unchanged over the next six months, fell 1.5 percentage points to 27.5%. This is the 19th time in the past 20 weeks that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 1.1 percentage points to 39.4%. This is the highest level of pessimism since October 6, 2011. This is also the third consecutive week that bearish sentiment has been above its historical average of 30%.

Due to the timing of our survey (Thursday through Wednesday), it is too early to tell if Wednesday's coordinated central bank action and the resulting rally have affected individual investor sentiment . The longer trends show a lasting cautiousness on the part of individual investors with bearish sentiment registering above-average readings for 35 out of the past 41 weeks. (The level of bearish sentiment exceeded the level of bullish sentiment 18 times during that period.) Market volatility, slow economic growth, European sovereign debt problems and Washington politics are all adversely impacting individual investors' moods.

This week’s sentiment survey ask AAII members how, if at all, the congressional super committee's failure to reach a compromise on a long-term deficit reduction plan affected their sentiment towards stocks. The majority of respondents said that it didn't have an impact, though many had expected the committee to fail. A sizeable minority said the lack of compromise made them more bearish.

Here is a sampling of the responses:

  • “I never figured the super committee would achieve anything, so I am just staying the course (with my investments).”
  • “This was all political theater. It was never intended to reduce the deficit, so it had no change on my outlook about the direction of the market.”
  • “No impact. I believe the lack of any compromise coming from this special congressional committee was already priced in.”
  • “Definitely a negative. I can't have much faith in our economy when our government officials can't accomplish the goals mandated by to them by law.”
  • “Neither U.S. nor European Union 'leaders' seem capable of managing their responsibilities. I am angry at them and fearful for our economies.”

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor