”So while this action should be bearish for the USD, the impact should not be as dramatic as was the case during similarly coordinated efforts during 2008 and early 2009, we believe.”
From Bob Lynch in FX strategy, NY…
The ECB announced that it will provide additional USD funding to the Euro area banking system in coordination with the reactivation of a USD swap facility with the Federal Reserve.
The Fed’s USD swap facilities with other central banks were established and expanded during the financial crisis in response to similar pressures in the funding markets, where foreign banks were unable to obtain sufficient amounts of USD funding in the interbank lending market. When that occurred, many financial institutions turned to obtaining the USD funding they needed
in the FX forward market, which had several consequences. Simply and most importantly for the FX market, the additional demand for USD coming through the FX forward market tended to put upward pressure on the spot USD. In addition, that demand resulted in dramatic skewing of the cross currency basis swaps, a condition which we have occasionally highlighted and which has become more prevalent recently with the latest round of stresses in European financial markets generally, and among European financial institutions in particular.
In the past, providing this extra USD liquidity helped alleviate those pressures in the FX forward market, reduced the skew in the cross currency basis swaps and, most obviously relieved upward pressure on the USD. We have every reason to expect a similar reaction this time around, although we would observe that the level of stress in markets – including the extent of the USD’s recent gains – have been less extreme than was the case during the more problematic periods during the financial crisis, the post-Lehman bankruptcy period in particular. So while this action should be bearish for the USD, the impact should not be as dramatic as was the case during similarly coordinated efforts during 2008 and early 2009, we believe.
In terms of specifics, the ECB will conduct three separate USD liquidity operations with maturities of approximately three months each, in full allotments (i.e. as much as the banks demand) and is designed to cover banks funding needs over the end of this year. They will be conducted October 12, November 9 and December 7, and the three-month term of these operations will help to specifically address the “turn” of the year period where funding squeezes develop even during normal market conditions (and markets remain far from normal).
This will be done in addition to the existing 7-day USD auctions currently in place, although we would note that the 7-day facilities have not been utilized much at all (aside from small takedowns in those auctions this week and during one week back in August), in part because funding operations on a week-to-week basis is clearly not a favorable method for a bank to fund its liabilities/operations.
The fact that the first auction will not be held until October is curious, however, and it leaves open the chance for additional USD funding squeezes to materialize for nearly another four weeks. We’ll see if that schedule changes or is otherwise brought forward. But the timing of the operation suggests that there will still be potential for renewed funding-related gains in the USD in the coming weeks should financial markets stresses intensify.
For now, however, the positive announcement effect of this measure alongside the notion that officials are attempting to get back out in front of this important aspect of financial market operations has weakened the USD against most of the majors. Coming on top of the de-stressing in financial markets that has taken place in recent days, this should-and has-contributed to further gains in EUR-USD as the currency pair continues on a more sizeable retracement of the selloff from late-August.
HSBC Global Research