The Federal Reserve sent stock investors an early Christmas present Wednesday in a coordinated action with five other central banks, lowering the cost of dollar funding by 50 basis points.
The fresh injection of liquidity which the central banks undertook to ease Europe's sovereign debt crisis sent global stock markets soaring; the Euro Stoxx 50 index shot up 4.31% and the S&P 500 index soared 4.33%. But many investors unfamiliar with the Fed's kit of monetary tools may be wondering what has happened to cause such market jubilation and how lasting its effect will be.
What has happened in a nutshell is that the Federal Reserve–though it acted in concert with other banks, it is really the Fed's action that has any meaningful consequence–has made dollar loans much cheaper and more available to European banks. And this badly needed source of liquidity to Europe's banks actually underscores how damaged the European financial system is.
Europe's banks have essentially stopped lending to one another and have turned to the European Central Bank. By lowering the cost of the overnight dollar index swap rate, the ECB can meet European banks' funding needs on a more affordable basis. But this indisputably good news nevertheless highlights the fact that the ECB is supporting bank operations, which is indicative of a rather unhealthy market.
Imagine a patient on life support. He is using a ventilator to get oxygen into his lungs, but the ventilator is partially obstructed. Quick-acting medical technicians remove the obstruction or perhaps replace it with a better tube. This medical team has thus facilitated the patient's breathing–just like the Fed has provided lending facilities for zombie banks on life support.
But it is important to understand that a ventilator does not treat a disease; it is merely life support. And, so too, today's actions by the central bank have not addressed the structural problems that have placed the Eurozone on life support. Actually, they make those problems somewhat more apparent, even while prolonging its life.
World markets shot up on Oct. 27 after Eurozone leaders announced a comprehensive solution to the continent's debt crisis. A key part of that solution was the expansion of a European stabilization fund that was to be quadrupled to 1 trillion euros. European finance ministers–one month later–have already acknowledged they will get nowhere near that goal, and whatever amount they manage to achieve will likely be insufficient to rescue Spain and Italy.
Indeed, while the stock market is having a good day, investors would be wise to pay some attention to the bond market. Italian 10-year-bonds are still above 7%! Bond investors have lost faith in the Eurozone, which they view as lacking the resources, financial and political, to fund their expensive welfare states.
With today's meteoric rise, the stock market may also be registering its hope or expectation that the Fed will lower its discount rate to U.S. banks to even the playing field with European banks who now ironically have cheaper access to U.S. dollars.
But longer term let's not forget that the credit rating agencies have put the U.S. on notice that it is on an unsustainable financial trajectory as well. Being in comparatively better shape that the Eurozone will not cure our ills if we, too, are breathing through the financial ventilator.
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