Danske Bank

Global: Coordinated Central Bank Action

Overview:
By 13:30 today the Fed and the other central banks had announced new measures to deal with the evolving distress in the financial markets. The Fed measures include an expansion of the securities lending programme and a continuation / widening of the 'dollar bridge' to Euroland and Switzerland aimed at promoting dollar liquidity.
Details:

At the domestic level, the Fed has announced an expansion of its securities lending programme. Under a new Term Securities Lending Facility (TSLF), the Fed will lend up to USD 200bn of Treasury securities to primary dealers for an extended term of 28 days (rather than overnight as in the existing facility) against collateral in other securities such as agencies and MBS. As the Fed states, the TSLF is intended to promote liquidity and to foster the functioning of the financial markets.

How should we interpret this move? On a general level, the Fed is saying that it will succeed in returning the financial markets to an orderly state where the liquidity is sufficient to price assets according to their true value. It is cutting rates and it is adding liquidity. The effect here is to reduce the premium on liquidity, causing a decline in the money market rates and a rise in the bond yields. The move is positive for the dollar as well. On a more direct level, the Fed is enabling the primary dealers to exchange assets that have perhaps a 20% equity weighting and are trading at a deep discount, with assets that have zero-equity weighting and a nominal value at parity. This step increases liquidity as well as working capital in the banking sector. It is not a permanent solution but a repo facility and is thus not a bail-out of distressed assets.

This new lending tool has to be seen alongside the TAF facility, the increase in the term repos (both announced on Friday) as well as the increased collateral based in the discount window. On top of this come the reductions in the Fed fund rate.

At the same time, the Fed also announced a continuation/widening of the 'dollar bridge' to Euroland and Switzerland through an increase in existing reciprocal currency arrangements (swap lines) with the ECB and the SNB. These lines will provide USD liquidity of up to USD 30bn with the ECB and 6bn with the SNB, representing an increase of USD 10bn and USD 2bn, respectively from the actions taken in December 2007. These swap lines will so far run to 30 September, 2008.

The BoE and BOC have both announced an extension of longer-dated repos against a wider range of collateral.

Market reaction:
The initial market reaction was positive and closely resembled the reaction following the announcement of the TAF auction facility in December, ie, equities and bond yields moved higher in combination with a stronger USD.

More specifically, the odds for a 75bp cut at the March meeting were reduced, but remained above 50-50. Reflecting this, repricing 2-year and 10-year government bond yields initially rose around 20bp and 10bp, respectively. US equities welcomed the move and rallied by more than 2%.

In the currency markets, EUR/USD has dropped by more than a point from a new high at 1.5494. The move is logical as a knee-jerk reaction but does not in our view represent a turning point to the EUR/USD uptrend. JPY has also sold off, which follows on from the drop in risk aversion and the rise in equity markets on the back of this. NZD/JPY is up by 2.8%. EUR/CHF has risen by 0.9%. Again we treat these moves as corrections to an underlying trend.
Assessment & Outlook:

The Fed means business. It has told us plainly that it is prepared to go a long way to secure the functioning of the financial markets. It is cutting rates aggressively and is easing liquidity constraints at the same time. Although the move today does not represent a final solution to the lack of value or liquidity in MBS products it does give primary dealers a way of getting low-value bonds off their books at least temporarily. The effect has to be positive for money market rates and spread products.

At the same time, it is hard not to see the Fed as responding to a series of shocks again and again. So far at least, the actions taken have not been sufficient. There is no guarantee that what it has done today will be enough this time around. But at least for now the markets may again enjoy the support of the central banks.

To the extent that an expansion of the lending programme is able to ease the tensions in the financial market, the likelihood of a 75bp cut at the March meeting could drop further. For now we stick to our expectation of a 50bp cut at the March meeting. That said, the FOMC will probably not dare to disappoint if the markets remain settled on the expectation of a 75bp cut.

The move today will help to provide a lower boundary for bond yields - at least in the short term. In the longer term, the direction for the bond yields will ultimately be determined by the direction of the economy. Here risks remain skewed to the downside.
Fed statement:

Since the coordinated actions taken in December 2007, the G-10 central banks have continued to work together closely and to consult regularly on liquidity pressures in funding markets. Pressures in some of these markets have recently increased again. We all continue to work together and will take appropriate steps to address those liquidity pressures.

To that end, today the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing specific measures.

Federal Reserve Actions
The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF.

In addition, the Federal Open Market Committee has authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008.

The actions announced today supplement the measures announced by the Federal Reserve on Friday to boost the size of the Term Auction Facility to $100 billion and to undertake a series of term repurchase transactions that will cumulate to $100 billion.