The European Bailout's Implications for EUR/USD Traders

05/12/2010 9:03 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The big story in the financial markets this week is the mammoth EU/IMF rescue plan. A lot has been written about the plan on many sites, including our own. Given that the plan, which in many ways is just as significant as the TARP, will be the focus of the financial markets for weeks to come, it is important to have a good understanding of the details and their implications for the foreign exchange market. Over the past few weeks, uncertainty in the euro zone has affected risk appetite in assets across the globe, and even with the rescue plan developments in Europe, it will continue to dominate trading in the coming weeks. The price action in the forex market indicates that even though investors are relieved to see this major announcement from EU/IMF/ECB, they are not completely confident that it will be a game changer. The goal was to spread calm through the financial markets, and if you look at the VIX, which fell sharply, or equities, which rose significantly, you could say the goal was achieved, but if you look at the move in currencies, you would be more skeptical.

How Much Money Is Involved?

In US dollar terms, the rescue package is worth approximately $1 trillion. In euro terms, the EU/IMF have agreed to a EUR750 billion plan that would involve up to EUR440 billion in loan guarantees, EUR60 billion in emergency funding from the European Union, and EUR250 billion from the IMF. The ECB also started to buy government bonds, but failed to provide any specifics. Although 27 different nations are involved in the bailout, most of the money will come from the 16 members of the euro zone.

What Was Announced?

In a nutshell, the following announcements were made:

1. New EU special purpose vehicle (SPV) to distribute the new loans. This is where the big questions remain (see below).

2. New swap lines with the Fed, BoE, SNB, and BoC to ease liquidity. In other words, the Fed will ease demand for dollars by reopening the spigot vis a vis other central banks.

3. ECB government bond and corporate debt purchases. This undermines the credibility of the central bank.

4. The EUR60 billion in emergency funding will be made available immediately, but it could be sometime before the larger loan guarantee package is made available.

According to the ECB…

In view of the current exceptional circumstances prevailing in the market, the governing council decided:

1. To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments, which are dysfunctional.

2. To adopt a fixed-rate tender procedure with full allotment in the regular three-month, longer-term refinancing operations (LTROs) to be allotted on May 26 and on June 30, 2010.

3. To conduct a six-month LTRO with full allotment on May 12, 2010, at a rate that will be fixed at the average minimum bid rate of the main refinancing operations (MROs) over the life of this operation.

4. To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of seven and 84 days. These operations will take the form of repurchase operations against ECB-eligible collateral and will be carried out as fixed rate tenders with full allotment. The first operation will be carried out on May 11, 2010.

NEXT: Unanswered Questions, Implications for EUR/USD

|pagebreak|

What Are the Unanswered Questions?

With Angela Merkel’s party losing majority, it will take a few days—if not a few weeks—to get the rescue plan through the upper and lower houses of Parliament. We saw how long it took to get to get the Greek bailout plan approved, and we can only imagine how long it will take for this plan to be passed.

1. What will be the exact mechanics behind how the special purpose vehicle will provide the loan guarantees to member states? What are the rules and terms of contribution and aid?

2. How long will it take before the SPV is approved by individual nations?

3. Will Greece accept these terms? Will they amend it?

4. Can all of the euro zone countries afford to contribute to the plan, and will the countries seeking aid be able to handle the tough conditions that may accompany the loans?

5. The IMF supposedly has $268 billion left. Where are they getting the rest of the money? Most likely from US taxpayers!

6. What is the size and scope of the ECB’s bond purchases?

What Are the Implications for the EUR/USD?

Considering that the ECB’s decision to buy government and corporate bonds is akin to quantitative easing (QE), it offsets some of the positive impact on the euro. The ECB has pledged to sterilize the intervention, which would neutralize the monetary policy impact, but complete sterilization may be more of a medium-term goal than a near-term one. Comments from ECB member Weber suggests that he may be one of the critics voting against government bond purchases as he warned of the significant risks. In the near term, the rescue plan will help to limit losses in the euro, and we believe that Thursday’s low of 1.2521 in the EUR/USD will become the currency pair’s near-term bottom. However, gains should limited until some of the above questions are answered. Don’t forget early-September 2008, when US treasury secretary Hank Paulson put the “bazooka” on the table by effectively nationalizing Fannie Mae and Freddie Mac and hoping the markets would calm down, but just days later, Lehman Bros. collapsed and the entire financial system went into a tailspin.

By Kathy Lien of GFTForex.com

Related Articles on FOREX

Keyword Image
The Fabulous Shrinking Renminbi
09/27/2017 1:13 pm EST

As of August 2015, renminbi (RMB) in payments globally accounted for 2.8 percent of the total, the f...