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Dollar Firmer as Traders Eye Liquidity

The currency market has its eyes set on money market conditions.

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


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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One point being driven home by the price action is the difference between liquidity and volume. It is easier to get volume numbers from exchanges rather than from over-the-counter markets. Turnover in the

S&P 500

, for example, is well above its 20-day and 90-day averages, but there is direct and indirect evidence of the lack of liquidity.

The same is true in Japan. The value of the turnover today in the first section of the Tokyo Stock Exchange was about JPY4.7 trillion (about $40 billion), which is nearly 60% above the three-month daily average. The turnover value yesterday was a record JPY5.3 trillion. Yet press reports and the price action indicate a shortage of liquidity.

There is increased speculation that the turmoil in the capital markets will affect the conduct of monetary policy -- not just the injection of liquidity but in terms of interest rates. The August Fed funds futures reflect increased speculation that the FOMC may have to cut rates before the Sept. 18 meeting. We noted earlier in the week that the high confidence that the BOJ would raise rates at the Aug. 22 meeting had waned in recent days.

IMF opined that it should not be in a "rush" to adjust rates as inflation is not a threat. Earlier today, the September Euribor futures contract reached its highest level since mid-May; this also reflects speculation that the market turmoil will deter the ECB from making good on Trcihet's signal of a rate hike.

The risk is that the euro re-tests the $1.3600 area. A convincing break of this area would undermine the euro's medium-term technical tone and warn of a move toward $1.34. The trend line drawn off the late-January low and hitting the mid-June low comes in near week just above $1.34. As it often does, the British pound is leading the way. A break of the $2.0140 area signals on $2.00 at least. The dollar is poised to test the JPY117.30 area, and a convincing break points to JPY116.00.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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