Dollar Firmer as Traders Eye Liquidity

The U.S. dollar is mostly firmer, though the low-yielding yen and Swiss franc are also benefiting from the continued risk and leverage reduction in the markets. The major emerging-market currencies are largely flat. Equity markets have fallen, but the market's focus is on the money market conditions.

At least five central banks have injected liquidity into their domestic banking systems. The amount injected yesterday was more than after the events of Sept. 11, 2001, largely owing to the ECB's 94.8 billion euro provision. On 9/11 it had injected near 70 billion euros. That one-day operation was replaced with a three-day injection today, which provided a little more than 61 billion euros at an average rate of 4.08%.

Thursday's operation was fixed a 4%, and today's had a variable rate with the marginal rate today of 4.05% and average rate of 4.08%. Yesterday the ECB accepted all bids. Today it received 62 bids for a little more than 110 billion euros. The different terms may be a way that reveals a bit more granular information about the state liquidity. Overnight rates had risen to about 4.27% compared with the ECB's 4% benchmark.

The fact that yesterday's operation was conducted at 4% sent an important signal to the market that this was just a liquidity injection and not a signal of a rate cut. Today the ECB called its operation "fine-tuning."

By providing extra liquidity into the banking system the central banks are recognizing a distinction between the credit finance adjustment that was taking place, and the evaporation of short-term liquidity. The former, while less orderly than many investors and policy makers would prefer, was not eliciting a policy response and was seen as largely a desirable event. The liquidity squeeze is thought to have more potential to disrupt the macro-economy.

Given the other factors, such as the Treasury's quarterly refunding, the Fed's injection yesterday was rather miserly compared with the other injections. Something on the magnitude of $13.55 billion to $15 billion was the projection of the Fed's open market operation. The Fed's two repo operations provided a total of $24 billion. Half of this was a one-day operation, which is likely to be replaced today by at least a three-day operation.

Fed officials need to be careful, because if too much money is injected and the Fed funds rate slips below 5%, the market may misread this to be a rate-cut signal, and that would have its own knock-on effects.

On the other hand, the Fed, like other central banks, wants financial institutions and investors to be confident that the lenders of last resort are a strong backstop. The RBA got into the act earlier today with about a $4.2 billion injection, its largest in three years. The BOJ injected about $8.5 billion, as its overnight called rate rose 5 to 6 basis points above the 0.50% target. A signal being sent by these injections is also one of coordination. There is no doubt the central banks are in communication with each other.

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