QE# is Here; Moral, Don’t Fight The Fed

This morning world central banks announced they were printing money er uh, monetizing the debt, I mean, they cheapened borrowing costs worldwide for US dollars by lowering interest paid on the borrowing costs by .5%.

In the financial markets, the most immediate impact was seen in stock markets. The S&P Index ($SPY, $ES_F) rallied fifty points. Tip of the hat to SellPuts for the chart.

The market may or may not hold a rally, but in the CME’s ($CME) short term interest rate contracts ($GE_F) there was a lot of action. There was a 21.5 tick move in the fourth month of the Eurodollar contract. Normally, this contract moves between 2-7 points in a day. The tick value is $12.50, and more business is done here in one day than in an entire year on the New York Stock Exchange ($NYX). That means there was a $268.75 move already today in the futures, and most of the people that trade them have a lot more than 100 contracts on.

What the banks did was adjust the London Interbank Rate (LIBOR). This is the value of interest paid to borrow dollars for banks outside the US. Within the US, the similar rate is the 30 day Treasury, or the Fed Funds rate($ZQ_F). As you may know, interest rates have an inverse relationship to their quoted price. So if someone tells you the actual rate moved lower, the quoted price of the security or future moved higher. That confuses a lot of people but it has to do with the math of figuring them out. For example, Eurodollar (LIBOR) rates are quoted in 100-99.35=.065% which is the expected future value of interest paid on short term rates for March of 2012. The December 2011 rate quote currently is 100-99.50=.05%. Understand?

For people that could care less about the trading of esoteric products like Eurodollars, why does it matter?

Eurodollars tell you if banks feel confident lending to each other. The lower the rates, the more confident they are. If rates start to move higher, they are less sure of each other’s financial health. When rates start to track significantly away from the published Fed Funds rate, then you know there are severe problems. In the 2008 financial melt down, Eurodollar futures traded at significantly higher interest rates daily. The long end(30 year bond $ZB_F, 10 year note$ZN_F) of what’s known as the “yield curve” traded at rates that were lower.

If you have an adjustable rate mortgage, the rate for that mortgage is set by the value of the Eurodollar future. That’s one way world financial systems are tied together. European banks were having funding problems. They didn’t trust each other enough to lend large amounts of money back and forth freely, so Eurodollar rates were creeping higher. This was a reflection of risk present in the market. If UBS can’t look at Credit Suisse and guarantee that it’s getting paid back in a timely manner, UBS demands a higher rate of interest from Credit Suisse. That higher amount of risk in Europe affects the adjustable rate mortgages US banks charge their customers.

Fixed rate mortgages are tied to the longer end of the US Treasury Interest rate curve. The reason for that is because banks can lend their money to you, have a guaranteed fixed stream of payments and hedge the risk they assume in the futures contracts.

That’s why all this worldwide financial stuff means something to the average Joe on the street.

You also might have heard of the terms QE1 and QE2. Well, this is essentially QE3. QE stands for quantitative ease. What happens is the central banks, in the US case the Federal Reserve, steps into the market and begins buying Treasuries. Today, they announced that they were going to buy them in the short end of the yield curve to make sure there was no cash crunch for short term bank borrowing. When the central bank buys an interest rate security, it pays for that security in US dollars. The entity that sold that security gives up the security, and gets dollars in return. Then they either lend out those dollars, or they invest them in another security, or commericial interest rate product.

By executing QE#, the central bank puts more dollars in the hands of the banks-increasing the supply of dollars. Absent an increase in the demand for dollars, the value, or price, of the dollar must fall. If the broader economy heats up, and the central bank doesn’t do anything to change its course of action, we will get inflation. If the economy begins growing faster than the rate of inflation, it’s not a big deal. No growth with continued QE policy, and we get stagflation. That’s when it hurts.

That’s why you see commodity prices go up. All the world trade is done in US dollars. After the central bank action of QE, it will take more dollars to buy the same amount of commodity. This morning, Gold ($GLD, $GL_F) and Oil ($CL_F) had big moves to the upside after the announcement.

I don’t agree with the Fed policy of quantitative ease because there isn’t really a way to end it. It becomes like heroin to a heroin addict. Start with a little and then you need more and more to get that high.

The only way to end it is to fix fiscal policy. Right now with the loggerheads we have in DC, that’s not happening. Look for more and more variations on QE up until November of 2012.

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UPDATE

One aspect of today’s move that I neglected to mention was the swap facility created by the US Federal Reserve. It’s an important point. The swap facility is for central banks only. The ECB will be able to sell securities to the US Federal Reserve and get US dollars in return. When they pay those dollars back, it’s done at the price the initial swap was executed at. There is no currency fluctuation risk, no other types of risk. The ECB can lend out those dollars as they see fit. Other central banks get the same deal. It’s one way for the Fed to ease liquidity pressures when the interest rate is already at 0%.

tip of the hat to Ace.

  • Sray1967

    Until today, SWAP spreads have widened.  ED’s went lower in price  as LIBOR rates went UP while US treasuries rallied and rates dropped as they provided a flight to quality.  Swaps widening is a bad thing.

  • Ddurchholz

    A Fed Reserve explanation of the move…. http://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm

    Dale

  • Anonymous

    How is there no risk, if the value of the dollar is diluted by easing and the fed is paid back with the same number of devalued dollars?