ECB moves into FX

Some interesting movements in Euroland last night.

Last week I stated that the lack of definitive action by the Euro-elite was morphing the issue of sovereign debts slowly into a banking crisis. We have seen that recently in the European CDS market, and that continues:

The cost of insuring European sovereign and corporate debt against default rose Wednesday, after a meeting Tuesday between French and German leaders failed to deliver the crisis-busting initiative for which financial markets were hoping.

German Chancellor Angela Merkel and French President Nicolas Sarkozy said a mixture of increased economic coordination and tighter fiscal discipline would help restore investor confidence in the euro zone, but also said it is too early to introduce common euro-zone bonds.

The meeting’s result was hardly a surprise, although market participants had been expecting a stronger response to the recent escalation in the sovereign-debt crisis.

“Any step closer towards a fiscal union is a welcome step,” said Daiwa Capital Markets analyst Tobias Blattner. “But what is proposed yesterday is only a tiny step.”

In credit markets, the disappointment helped push indexes wider for a second day running after the extreme volatility of last week.

We have known for some time that the ECB has been holding both the Euro-based interbank liquidity market and the sovereign bond market together with its balance sheet. But as I reported late last week the international liquidity being provided to banks is drying up and this is an achilles heal for the European banks.  They have been borrowing short in US dollars to fund long term Euro-denominated assets. This means they constantly need a rolling supply of $US in order to meet the repayments on their prior short-term funding obligations as their Euro assets mature more slowly. If the holders of $US no longer think they are a safe bet then they are caught in a good old fashioned banking liquidity trap.

We have seen evidence of this over the last few weeks as European banks started to tap the FX markets for $US swaps:

European banks are relying more on the foreign exchange market to obtain dollar funding, as fewer investors are buying their U.S. short-term debt due to fears that the region’s debt crisis could spin out of control. In the euro/dollar cross-currency market, where a bank can swap euro interest payments with a lender for dollars, the three-month cross rate spiked to minus 84 basis points, the highest since the end of 2008 during the global financial crisis.

This rate has doubled in three weeks, but it was still far below the peak of minus 300 basis points seen in the fourth quarter of 2008 when money markets froze after Lehman Brothers collapsed. Back in early May, it stood at about 18 basis points.

“It is the biggest sign that significant stress has emerged in the dollar funding market in Europe,” said Amrut Nashikkar, analyst at Barclays Capital in New York.

The ECB has a $US swap-line in place with the US Fed, but this is a last resort for banks because by using it they could be seen by the markets as having broader liquidity, and therefore solvency issues. Last night however this service was used by one bank who obviously couldn’t find anyone else to hand over $US 500m in a 7 day trade at a price less than 110bps plus whatever ECB stigma is worth:

No one is quite sure which banks this is. Soc Gen is the most likely candidate according to the market because it has already had to defend itself against rumours, has taken writedowns on Greek debt and some newspapers have been reporting that Soc Gen executives have been having secret meetings with the French Government over the last week.

I am sure we will discover which particular bank it is over the coming days, but more importantly at this stage the fact that an institution has now used this facility for such an amount is more the issue. It proves that a bank is struggling to get market support, and that in itself will be enough to ratchet up the nerves of investors and banks alike. I expect to see a CDS effect on this news and, given that the FX rate is fast approaching the ECB rate, I can only assume that the ECB is about to take on Euro bank FX liquidity on top of its other duties.


  1. Merkel-Sarkozy are just itching for a chance for fiscal union and the chance for them to be in charge of every Euro country. A couple of bank failures would give them that chance as the population of France will demand it and the Germans see it as their destiny even if they have to wear some financial losses to get there.

    • Having not spoken to either Merkel or Sarkozy, I cannot vouch for what they would really like to do, but my guess is they want absolutely nothing whatsoever to do with fiscal union. There is no constituency for this in either Germany or France – only determined resistance.

      Some of the political and financial operators doubtless want it to happen, not least because without it the Euro system is vulnerable to collapse. But I imagine if you asked your every-man Italian or Spaniard if the want to fused politically with the Germans and the French, they would be opposed.

      Since fiscal union is not possible without the active consent of everyone involved, it is safe to say it will not happen. And without it, the EuroBond idea will not happen either.

      • “But I imagine if you asked your every-man Italian or Spaniard if the want to fused politically with the Germans and the French, they would be opposed.”

        I think you’d be surprised! Many Italians are so fed up with their politicians and their struggling economy, they see a German invasion as a possible future solution to their problems!

        Not by means of an army, but that is what is slowly actually happening!

      • I’m not sure it matters what the citizens want David if you look at how the EU was started. I agree with you on the EuroBond, but if it comes to default it will happen IMO, and it won’t matter what the other members of the EU want, or the citizens.

        I see the term Merkozy being used now, but if you look who is the winner it’s Germany, and France will not stand that for long. France is in real trouble IMO.

      • “Since fiscal union is not possible without the active consent of everyone involved”

        the whole Euro experiment is without consent of the people

  2. This is like watching Lost, in slow motion. The suspense of seeing how the ever present Euro-crisis will end is killing me.

    • Europe is even worse than the US on transparency. A lot will happen that we will never know. They won’t let any banks or countries fail in the open, and it will take ages to know what really went on.

      Look, the Fed does QE and hell breaks loose. The ECB is buying Italian and Spanish and Portuguese and Greek and Irish bonds and no one seems to care. We do not even know how much or how long until after the fact.