Mayday

We turn to Europe in this commentary as important events are occurring there behind the scenes and Asia has gotten the lion's share of the attention recently. The mariner's distress call actually comes from French, where "m'aidez" simply means "help me." We thought that would be a particularly appropriate title as Europe's financial system is starting to show signs of severe distress. From the actions of the CBs over there, we can infer that the problems there may be significantly worse than here in the US. Current open market operations show that the ECB has 451 billion Euros (about $640 billion) outstanding. This dwarfs the Fed total of just over $300 billion - including all liquidity facilities. It's pretty clear that there are many European banks in deep, deep trouble.

Starving for Dollars
It is also becoming increasingly clear that the European financial system has a desperate shortage of dollars. Since much of the debt outstanding is denominated in dollars and many European banks have taken in dollar deposits as well, there is a need for them to transact in our currency that is not reciprocated. When the Fed and foreign CBs set up the currency swaps, there was some suggestion that the purpose was to give the Fed enough Euros to intervene in the currency markets. That really didn't make much sense as the Treasury and the Fed have conducted a sub rosa weak-dollar policy for years. The logical and obvious explanation is now coming to the fore - Europe is seriously short of dollars and if they were forced to go out into the market and buy dollars, our currency would strengthen too much for the planners at the Fed who have been attempting to devalue it.

The bid to cover ratios from recent auctions make the point quite forcefully. The last set of TAF auctions in the US produced ratios of 1.51 and 2.19 (for the initial 84-day facility). The comparable ECB auctions in Euros had a bid to cover of 1.58. But ECB dollar auctions were bid at 4.56 and 3.85. US banks' demand for dollars appears to be roughly equal to Eurozone banks' demand for Euros. But Eurozone demand for dollars is twice as great as either one. This trend is confirmed by the result of the Swiss dollar auctions. Those had bid to cover ratios of 2.90 and 4.90. Finally, note that the Fed is not auctioning off Euros or Swiss Francs to anxious American bankers.

In addition, the high-yield bond market in Europe is completely frozen. Not one junk issue of any size has come out of Europe this year or for quite a few months of 2007. Retail sales there are falling farther and faster than in the US and the housing bust there has barely begun. Granted that theoretically the ECB had more room to cut rates than the Fed but the strength of unions and the social program costs make a wage-price spiral much more likely in the Eurozone, which seems to be constraining the actions of the ECB.