John  Browne

Last week, with liquidity concerns reaching a crisis point for Europe, central banks around the world, led by the U.S. Federal Reserve, stepped in to provide emergency measures to insure that the financial gears continue to turn. At the same time, the European Central Bank (ECB) yielded to political pressure to rescue the world's second currency by using an IMF smokescreen to circumvent its own prohibition against making loans directly to member countries. Lastly, Germany indicated possible agreement to provide more bailout funds if Eurozone countries would agree to yield more fiscal sovereignty to German control. Taken together these measures have certainly provided some relief to markets, as the current rally attests, but the long term ramifications are harder to assess.

For decades, European banks have been acquiring what are known as "Eurodollars," which are simply U.S. dollars held by non-U.S. residents. To a large extent, these funds are the result of excess numbers of greenbacks sloshing around the world due to U.S. trade deficits. Trillions of Eurodollars are deposited at European banks, which are usually loaned out on a fractional basis. To redeem these loans, European banks need a steady stream of dollars which they traditionally get in the London-based Eurodollar interbank market. However, as the euro crisis has evolved, U.S. banks have correctly become distrustful of Eurozone bank's exposure to the collapsing sovereign bond market, and have reduced overseas dollar lending. While the ECB can print euros, only the U.S. Fed can print U.S. dollars. Hence the emergence of a dollar liquidity crisis.

Wisely and promptly, in a desperate rescue attempt the Fed agreed with the ECB to a new central bank swap of U.S. dollars for euros at a fixed exchange rate. The ECB was able to provide the dollar liquidity to dollar hungry Eurozone banks. This, in turn, lowered the cost of all other dollar swaps. The relief sent the Dow up 400 points in a single day. From our perspective, by swapping dollars for euros the Federal Reserve is actually taking risk off the table, and the move, in my opinion, does not present a worsening of U.S. finances. However, should the euro collapse, U.S. taxpayers will be on the hook yet again.

But liquidity alone will do little to solve the underlying insolvency of many European nations, which may only be absolved through massive debt forgiveness. However, that problem was swept under the rug yet again by deft political maneuvers.


John Browne

John Browne is the Senior Market Strategist for Euro Pacific Capital, Inc.
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