Today In Silver

On January 29, 2009, the Federal Reserve released a statistical report that appears to have helped shed some light on recent events in the Treasury market: H.4.1 Release - January 29, 2009. This release confirms for the first time that the largest boost in Federal Reserve bank assets during the credit crisis has been none other than Central Bank Liquidity Swaps. Until January 29, all we knew was that a category of Federal Reserve assets called “Other Assets” had grown by leaps and bounds up to the middle of December before topping out and then plunging in the past few weeks.

What are Central Bank Liquidity Swaps? Here is the definition in the Fed’s own words:

Each swap arrangement involves two transactions. When a foreign central bank draws on (obtains funding under) the swap line, it sells a certain amount of its currency to the Federal Reserve at the prevailing market exchange rate in exchange for dollars. This market rate becomes the swap exchange rate. At the same time, the Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction in which the foreign central bank is obligated to repurchase the foreign currency at a specified future date. The second transaction is done at the swap exchange rate — that is, the same exchange rate as in the first transaction. The release shows the outstanding dollar value of central bank liquidity swaps in tables 1, 8, and 9. This value equals the sum of the dollar value of the outstanding swap drawings, which are valued at their respective swap exchange rates. The maturity distribution of these swaps is reported in table 2.

[...]

The Federal Reserve’s current program of temporary liquidity swaps was initiated on December 12, 2007, when the Federal Open Market Committee authorized swap lines with the European Central Bank and the Swiss National Bank. The program has since expanded to include additional central banks. Historical data on the current program of central bank liquidity swaps will be available in the historical data tables accompanying this release at www.federalreserve.gov/releases/h41/hist/.

In other words, these are currency swaps. The Fed receives Euros, Swiss Francs or what have you and issues U.S. dollars. Why? Presumably because the U.S. dollar is the world’s reserve currency used to settle the majority of international trade, and thus only the U.S. dollar can unclog a freeze in international settlements.

That might seem innocuous enough, but if we look closer at the data, we can discern some interesting goings on (the table with CB Liquidity Swaps can be found here: http://www.federalreserve.gov/releases/h41/hist/h41hist5.pdf). In particular, we observe a fairly interesting relationship between CB Liquidity Swaps, foreign holdings of U.S. Treasuries and U.S. Treasury prices. The following table includes data since the beginning of 2008 (click to enlarge).

There are at least 3 things that jump out from this chart. First, the acceleration in the purchase of U.S. Treasuries by foreign CBs and the increase in CB Liquidity Swaps both occurred in September 2008, at the depth of the credit crisis. Second, Treasury prices (at least at the long end of the yield curve)  initially dropped despite the presumed flight-to-safety buying that should have boosted prices. Third, Treasuries rallied very strongly as the CB Liquidity Swaps were topping out and then both started to decline seemingly in lockstep by late December.

One possible explanation of the relationship between CB Liquidity Swaps and Treasury prices is that the CBs used the swaps originally for the purpose they were intended: unclogging international settlements and clearings. If so, it is possible that by early December no more U.S. dollars were required for this original purpose and so the CBs started to buy Treasuries with the “excess” dollars.

A few other points:

• Treasury prices obviously move inverse to yield such that higher prices mean lower yields. Both the Treasury and the Federal Reserve benefit from higher prices although there are limits to this.
• For example, during December 2008 the rate on 3 month Treasury Bills reached 0% and even turned negative for a few days. The Federal Reserve was presumably not happy with this because its own target short-term rate is a positive value between 0% and 0.25%.
• Although the above chart shows 30 year U.S. Treasury Bond prices, the greatest effect of excess CB Liquidity Swap balances may have been on 3 month U.S. Treasury Bills because only a small portion of Treasury Bill principal is at risk from changing prices. CBs would presumably not want to expose themselves to large losses on principal from what amounts to a very temporary holding.
• The Federal Reserve appears to be content with the recent rise in Treasury yields, including the long end of the curve, because this will make it easier for the Fed to purchase Treasuries in the future. No such purchases have taken place so far despite the Fed hinting on a number of occasions that it is prepared to become a major buyer.

Assuming the above relationship contains some cause and effect and is not merely coincidental, my interpretation of the situation is that the Federal Reserve may be trying to create some space for its own planned buying of Treasuries. If this is the case, the decline in CB Liquidity Swaps is likely to precede a deceleration in foreign Treasury holdings and an acceleration in Federal Reserve Treasury holdings. Indeed, the above chart indicates that a topping out in foreign holdings may already be taking place.

Here are some possible near term outcomes of the above scenario:

• The U.S. dollar may remain relatively strong, or even rally, as foreign CBs replace their expiring Fed swaps by purchasing dollars in the currency markets.
• Treasury prices could eventually embark on another rally, perhaps creating a double top near the December 2008 levels (that would mean a corresponding double bottom in yields).
• Reserve balances created under CB Liquidity Swaps were unlikely to be available to the domestic U.S. economy as credit extensions. This could be a major reason — in addition to tighter credit standards — why the massive increase in the monetary base has not translated so far to a large increase in money supply as well as why it has not stimulated the domestic U.S. economy. On the other hand, should the Fed start to purchase Treasuries in earnest, the resulting helicopter dollars would presumably be available for credit extension.

What I’m basically saying is that the conversion of temporary CB Liquidity Swaps into permanent liquidity injections may represent Bernanke’s helicopter moving clear of the money drop so that people on the ground can start to gather up the dollars. That would certainly explain the Fed’s hesitance to start going down this path — once they start, it is very difficult if not impossible to go back.

On the other hand, if the draining of CB Liquidity Swaps can be accomplished without setting off another liquidity trap or otherwise necessitating immediate Fed purchases of Treasuries (for example, due to an unacceptable rise in Treasury yields), a major portion of the monetary activism undertaken by the Fed will have been successfully “sterilized”, even if temporarily.

I believe gold is particularly susceptible to the draining of CB Liquidity Swaps because a substantial portion of the monetary metal’s attractiveness is tied to an inflationary outcome to Fed monetary policy. If it looks like the CB Liquidity Swaps can be withdrawn in a relatively orderly manner not immediately requiring permanent offsets (large Treasury purchases by the Fed), some of gold’s short term desirability could fade given that CB Liquidity Swaps represented around 40% of the increase in the Federal Reserve’s balance sheet since the crisis began.

I’ll close by taking the advice of several commentors to revise my helicopter rotor updraft analogy or metaphor. Previously I’ve referred to new money being dropped from helicopters but being held up in the air by rotor updraft. Technically speaking, however, rotors don’t create an updraft but rather a wash and money dropped from a helicopter wouldn’t be held up but rather blown around. So, the corrected analogy is new money blown around by rotor wash. In any case, those who doubt the validity of this analogy (whether as originally expressed or the revised version) should try it sometime. Of course you’ll want to use fake money and make sure to clean it all up afterwards. Meanwhile, it remains to be seen if CB Liquidity Swaps represent money that was even loaded on the helicopter, much less dropped.

silverax Windbag Wisdom