Mixed views on “liquidity crisis” and the greenback

Global equity markets, spooked by a sub-prime mortgage crisis in the U.S., suffered a virtual freefall from mid-July to mid-August.

The decline was so severe, central banks around the world took the unusual step of providing funding — and lots of it — to their country’s banking systems in order to ensure the banks had enough liquidity to handle all potential withdrawals.

The European Central Bank ($130.7 billion), the U.S. Federal Reserve ($24 billion), and the Bank of Japan ($8.4 billion) began the process Aug. 9, with the ECB adding another $83.8 billion the next day and the Fed pumping in an additional $19 billion over a three-day period. Central banks in Australia, Hong Kong, and Canada soon followed suit.

The infusion, at least in the short-term, worked. Stock prices rebounded after Aug. 16 and volatility eased. That’s good news for central banks, even if not everyone is convinced there was a crisis to begin with.

“It’s more a crisis of confidence and doubt on the part of the lenders than it is actual defaults,” says Joe Trevisani, chief market analyst for FXSolutions. “The banks are providing extra money so people will go back to the markets and start lending money again. It’s really more [about] confidence than economic problems.”

Besides putting money into the system, the Fed also lowered the discount rate — the rate banks get charged for short-term loans — from 6.25 percent to 5.75. Additionally, the Fed extended the loan period from three to 30 days and encouraged banks to be more active participants “at the window,” as making short-term loans is known. Most analysts agree the Fed is doing what it can to avoid cutting the Fed Funds rate, which is the overnight lending rate.

Five large U.S. banks collectively borrowed more than $2 billion the day after the Fed changes, although the loans were more symbolic than anything — all the banks were well capitalized and could have received a lower interest rate by borrowing elsewhere.

“[Lowering the discount rate] is the right idea, but it’s mostly symbolic and intended to calm nerves,” says Brian Dolan, chief currency strategist at GAIN Capital. “Banks had effectively stopped lending to each other and needed a signal from the Fed that it was on top of the situation and prepared to act.”

Still, Dolan believes credit availability is a bigger problem than credit cost. He says lenders have lost their appetite for lending, and it may be a while before it returns. So while the rate cut lowers the cost of borrowing, it doesn’t affect the willingness to lend.

“That’s a function of psychology and sentiment and it will take more time to recover,” Dolan says.

Currency traders, though, are most concerned with how the current situation will affect the dollar. While the U.S. dollar index nearly made a new all-time low in early August, it bounced back for two weeks before falling again in late August.

There is a difference of opinion on where the dollar might be headed.

“The current effects on the dollar have been minimal,” says Joe Cusick, vice president of education for OptionsXpress. “But if the Fed is going to have to cut the Fed Funds rate more than 25 basis points, the long-term consequences will be negative — especially if it urns out there was no reason in the markets or the economy to do so.”

Trevisani also believes the long-term effects will be dollar negative, with interest rates playing a large role.

“The relative position is not going to change,” he says. “We were looking at the Fed on hold and the ECB about to raise. What we’re probably looking at now is the Fed cutting, and the ECB pausing. Relatively, that’s the same hing, and it will probably weaken the dollar.”

Dolan, though, isn’t convinced rate changes are a certainty, and as such he sees potential good news for the greenback.

“When risk aversion and volatility increase, the U.S. dollar and Japanese yen will benefit the most,” Dolan says. “As the situation settles down, the dollar and yen will come under pressure again. Overall, though, the unsettled environment makes further rate hikes less likely, and that suggests currencies with higher interest-rate expectations — such as the euro, the British pound, the Australian dollar, and the Canadian dollar — are most likely to weaken as those higher interest rate expectations are priced out.”