The collateral limits of coordinated action | FT Alphaville

The collateral limits of coordinated action

Wednesday’s central bank intervention is impressive in its symbolism but unlikely to do much more than buy eurozone leaders a few days.

RBS’ US rates team has provided a useful analysis of the move. The immediate background to the intervention, according to the strategists, is that European institutions have been having trouble funding in the US repo market so have turned to the currency markets instead — buying USD then reversing the transaction three or so months later. Hence the recent stress in the currency basis swap markets.

But what impact will the move have?

For people trading nearby LIBOR and EURIBOR contracts, nearby swap rates and 2- and 3-year swap spreads or cross currency basis swaps (or FX forwards) the impact is already large and meaningful and most likely not over. The impact on the European sovereign crisis? The direct effect is marginal. Italy, Spain, etc will still need to solve a crisis of faith in their debt. But the move has the right flavour as a symbolic gesture. Central banks can step in and solve liquidity problems and slow or even reverse the rise in LIBOR rates.

“Solve” might be putting it too strongly. For there’s more to the rationale than stress in the currency markets as negative yields on the German one-year attest. Buried in RBS’s next paragraph is why this is the case (emphasis ours):

We estimate that with the haircut change by the ECB and the swap line margin cut by 50bps that the effective rate is now around 71bps (thanks to Simon Peck for the estimate) so the basis swap market should be closer to that level and could collapse substantially from here—subject to an important caveat. The borrower still needs to post eligible EUR collateral. If we have a collateral shortage, that may be more difficult than posting margin for the FX transaction. But either way, we think the basis could fall farther, front Eurodollars could rally more, front-end swap spreads could come in from here and at the very least, today’s policy move suggests that there may well be more to come.

Without altering the underlying collateral shortage the move will only be a welcome but temporary reprieve. Everything still depends on the EU and the ECB.

Here’s RBS’ quick summary, which includes an interesting hypothesis for why the crisis could be over sooner than we think, which only a bank steeped in frugal, prudent, Calvinist values could make:

Bottom line:

Concerted central bank action is a positive

Adding in 1) Bund contracts have dropped 5 points since 11/9 (relative to ¥ of a point for TY), 2) Seasonal patterns that tend to support to risk assets, 3) This morning’s new EFSF proposals, and 4) as Margaret Kerins has been saying for weeks, a propensity for Europe to do whatever it takes to take most of the month of December off for holidays, we think there may be some momentum following this move.

Related links:
So much for that impact on currency basis swaps – FT Alphaville
Central Banks to the Rescue? What Today’s Action Means – CNBC