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Fed Could Lower Spread for Currency Swaps to Increase European Liquidity

May 26th, 2010 Michael McDonough

Rumors have been spreading across trading floors that the Fed may lower the penalty for using its dollar liquidity swap line to reduce stress in the interbank market.   As I mentioned in a previous note, a 100bp ‘penalty’ over the overnight indexed swap (OIS) rate for the Fed’s dollar liquidity swap line is preventing the tool from impacting interbank borrowing risks as LIBOR continues to climb.  The OIS rate currently stands at 0.22%, which means anyone utilizing the Fed’s swap program would be paying 1.22%, well above the current 3M USD LIBOR rate of 0.54%, leading to the programs ineffectiveness.   In fact, the ECB’s most recent offering for the program on May 19th lacked even a single taker.  If market speculation pans out and the Fed reduces the penalty spread to 50bps from 100bps, then the borrowing cost would fall to 0.72%–below the Fed’s discount rate of 0.75%–, but still remain well above current LIBOR levels meaning the impact could be minimal.

OIS (White) vs. 3M LIBOR (Orange)

Source: Bloomberg

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