The Federal Reserve is Buying Euro Debt and We are All Going to Pay

Two-weeks ago the Federal Reserve announced a coordinated effort by six central banks to make it cheaper to borrow dollars in emergency situations. The premium to borrow dollars overnight via foreign exchange swaps was reduced by 50 bps, and the timeframe to access this emergency cash was extended out to February, 2013.

This is old news of course, but the results of the decision are not.

The lowered rate opens up an arbitrage situation whereby a spread can be collected risk-free (barring a few low-probability outcomes). Banks and institutions in Europe as well as America and elsewhere are taking advantage of this free cash and are also exploiting it to buy en masse the debt of Spain and Italy. Essentially, the Fed, via swap lines is lending through foreign central banks to institutions and banks to immediately purchase debt, primarily that of Spain and Italy.

In essence, the Federal Reserve is buying Spanish and Italian Debt.

Not only is the manager of our sole medium of exchange risking our purchasing power to bail out the lifestyles and frivolousness of the European periphery, but they’re also bank rolling hedge funds in the process.

The announcement from the Fed came on November 30th, but the swap lines were not accessible at the discounted rate until December 5th, leaving two trading days for hedge funds and other large institutions with heavy cash positions to front-run sovereign debt buyers that would be making huge purchases on December 5th. If you factor in insider trading, which for an operation like this is an absolute certainty, traders had even more opportunity to front-run. Front-running means buyers with no interest to own something, buy in front of those who are actually interested in owning, and sell to them for a profit and to the ultimate owner’s loss. For instance, I buy at $90 knowing full well that natural buyers will be coming to market in two days. My buying drives the price up to $93 where I then sell to the natural buyers. I profit $3 from front-running, and the natural buyers lose that same $3 that they otherwise would not have had to pay had I not driven up the price. Now, magnify that $3 to a couple billion, and you can understand why hedge funds, institutions, and banks love it when the Fed gets into markets.

But there is something more inherently wrong with this situation, namely that our central bank is buying Italian and Spanish debt. The Fed will tell you of course that they are only lending to central banks, and that central banks, like the ECB, are the only counterparty. While this is true, that money is winding-up in banks all over the world, primarily in Europe, and they’re then turning around and buying dodgy debt. So should that debt plummet, like in the case of Greece over the past year, the central banks that the Fed has lent to, namely the ECB, will have to print their sovereign currency ad nauseam to come up with the dollars with which to pay us back. That would be disastrous. But it was a situation that we weren’t party to until last week.

Pundits downplayed this new Fed action on the day of its announcement, but the results of the subsequent borrowings have had significant market effects. Banks demanding dollars from the ECB through this facility came in over five times expectations at $52.3 billion. Purchases from this added liquidity brought yields on Spanish 10-year bonds down to 5.09 percent from 5.68 percent on the day of the borrowings. They had been as high as 6.7 percent when the initial front-running began.

Yields on Italy’s debt reacted the same. Italian 10-year yields fell from 6.68 percent to 5.93 percent on the day of the borrowings and had been as high as 7.3 percent. These are huge swings and they are all central bank orchestrated.

The same sovereign bond market reaction occurred this past August when the ECB stepped in through their Securities Market Program (SMP) and bought â’¬130 billion in periphery debt. I wrote about the ridiculousness of those purchases here and here. Following the ECB action, yields plummeted much the same as they did last week, but then traded back up as the purchases leveled off. Below is a chart that shows the yields of Spanish and Italian 10-year bonds overlaid with the purchases of the SMP program and the Fed’s latest swap operations.

It is clear to see the effect these central bank actions have on bond prices and their corresponding yields, albeit artificial.

You may be thinking that this is a good thing that the yields have fallen. After all, it is rising borrowing costs (bond yields) that are causing all the pain in Europe and anything the ECB or the Fed can do to bring these costs down is good. While that may be true in the short-term, if the long-term issues of insolvency aren’t addressed, a currency crisis could ensue, and it will be much more severe and many more years longer if it is postponed through short-term liquidity injections. Ultimately, the liquidity injections may not produce any positive results save for a few months of delusion from those thinking that the problem has been solved.

Consider Greece, which back in May, 2010 had the same episode of rising bond yields. The ECB stepped in through their newly created SMP providing â’¬70 billion to purchase the sovereign debt acting to avert what they deemed, a liquidity crisis. The below chart displays Greece’s 10-year bond yield overlaid with the SMP purchases.

It looks eerily similar to the first chart: yields are steady, yields rise, the ECB intervenes and yields plummet, yields trickle back up as the purchases level off. It is the exact same situation, at nearly the exact same yield levels, only a year earlier and a different country. Greek yields have since skyrocketed. The country is now bankrupt.

The following chart displays the Greek 10-year yield over the past two-years, the highlighted section being the time period of the chart above.

Remember that back in May, 2010 the ECB claimed that the situation facing Greece was nothing more than a liquidity crisis and that through purchasing its bonds, the crisis could be averted. This justified their intervention. It is now clear that Greece is in fact insolvent, and its bonds reflected a solvency crisis. Under such a scenario, no matter how much money is thrown at the situation, default is inevitable. Any money invested will be lost.

Looking at the first two charts it is easy to draw parallels, and the third chart may indeed be the future facing Spain and Italy. If that should prove to be true, and the situation in Spain and Italy is a solvency crisis misdiagnosed as a liquidity crisis, the ECB and especially the Fed has no business buying their debt. It is just wasting money on an inevitable default and compounding the problems of bankruptcy, spreading the pain to millions more people than is necessary.

Americans’ future now depends on the gambling of America’s central bank placing bets on the probability that the lifestyles of Spaniards and Italians are conducive to paying bills and balancing a check book.

Is that a wager you would make? Doesn’t matter, you already did.