The Fed's Operation Swap, Drop & Roll

Bob Froehlich Hartford Investor December 7, 2011

Maybe the most important thing in times of war is to have a plan. Did you ever notice how war plans always have cool names that seem to live on forever? For you military experts out there, I'll correct myself—they're not cool names, but rather code names. For example, the British counter measures against the V-2 German rocket, the world's first long-range ballistic missile, was called Operation Crossbow. The atomic bomb project centered in New Mexico was called the Manhattan Project, derived from the Manhattan Engineer District that managed the program. The code name for the American SR-71 spy plane project producing the fastest, highest-flying aircraft in the world was Oxcart. Finally, the American code name for the attack on the steamy jungle island of Okinawa in World War II was Operation Iceberg, which is where I got the title for this commentary.

Remember, if you're at war, you need a plan to win. Once you have a plan, it needs a code name that's cool. As investors, I think we're at war with these markets. If we're going to win this war, we need a plan, and that plan needs a code name. Actually, there are three great plans already out there to help us win this investment war against the markets. All I've done is name them. Of course, if you name them, you should explain them as well. My three plans for the war against the markets are "Operation Swap, Drop &Roll," "Operation Beer &Wine," and "Operation Beatles." Let me show you how all three of these great plans may work, beginning with "Operation Swap, Drop &Roll."

I'll begin with the "Swap" part of "Swap, Drop &Roll." Six central banks (the U.S. Federal Reserve Board, the European Central Bank, the Bank of Canada, Bank of England, Bank of Japan, and Swiss National Bank) all agreed to create temporary bilateral swap programs so funding can be provided in any of the currencies "should market conditions so warrant." These swap lines were authorized through February 1, 2013.

Next is the "Drop" part of "Swap, Drop &Roll." The Federal Reserve dropped the cost of emergency dollar funding for European banks as part of a globally coordinated central-bank response to Europe's sovereign debt crisis. The interest rate dropped from the dollar overnight index swap rate plus 1.00% to plus 0.50%, so that's a half a percentage point drop. This program was also extended to February 1, 2013. I view this coordinated action to drop the price of dollar swap arrangements by 0.50% as an attempt to make sure that we don't duplicate the "Lehman problem," when financial institutions went out of business due to a lack of short-term liquidity.

Finally, I'll address the "Roll" part of "Swap, Drop &Roll." The European Central Bank explained why this plan was developed as follows: "The purpose of these actions is to ease strains in financial markets, and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity." In other words, they want the money to keep rolling along to both households and to businesses. In case you were wondering, here's how it will actually work. Under the program, the Fed lends dollars to the European Central Bank and other central banks in exchange for currencies, including euros. These central banks then lend dollars to commercial banks in their jurisdictions through an auction process. The swap arrangements were first revived in May 2010 when the debt crisis in Europe worsened.

Here's how I look at this. This plan may ease strains in global markets and, at the same time, boost central banks' capacity to support the overall global financial system. All in all, this a pretty good plan.

Let's move on to the second plan, which I've dubbed, "Operation Beer &Wine."

An alternate name for this Operation could be the Merkel-Sarkozy Plan—I just decided to rename it. The Merkel part stands for Angela Merkel, the Chancellor of Germany. The Sarkozy part stands for Nicolas Sarkozy, President of France. So really, it's the German-French Plan, which is why I dubbed it "Operation Beer &Wine."

The "Beer" part represents Germany, which has 1,300 breweries producing more than 5,000 brands of beer. The Benedictine Abbey brewery is the oldest existing brewery in the world, brewing since 1040. And let's not forget that Munich's Oktoberfest in Germany is the world's largest beer festival. The "Wine" part represents France, which is the world's largest wine producer—easy to do when you're home to such a wide variety of grapes, including Cabernet Sauvignon, Chardonnay, Pinot Noir, Sauvignon Blanc, and Syrah.

No matter what you call it, here's the plan. Both Chancellor Merkel and President Sarkozy are pushing for fast integration of fiscal policy within the European Union. Up until now, all that's been integrated in Europe is monetary policy, which allows the European Central Bank to set a common interest-rate policy for all member countries. There's no such integration of fiscal policy, as individual countries are free to spend and tax as they wish.

This new plan will change all of that. If you peel back the onion, what this plan really does is force member countries to give up some of their sovereignty, as each member country would surrender some fiscal power and authority to a yet-to-be created European fiscal authority. This is no different than when countries were asked to give up some of their sovereignty by surrendering their individual power to set interest rates for their countries. The benefit of all of this would be a much stronger European Union.

This plan is a real game changer for two reasons. First, it would formalize a process to assure that individual countries actually make progress toward fiscal discipline—a primary goal that the European Central Bank is currently powerless to pursue. This, in turn, would remove the European Central Bank's concern that if they step up their purchases of an individual country's bonds, it would diminish that country's motivation and incentive to continue to pursue fiscal discipline. Once fiscal policy is integrated under this plan, these countries would have to continue along the path of fiscal discipline.

The second game changer would be even more dramatic. The plan would increase the odds of Eurobonds happening sooner rather than later. The creation of Eurobonds would serve as the key trigger to persuade countries to sign up for a politically unpopular loss of sovereignty. Second-tier countries in Europe are really at the crossroads. They either sign up for the plan now, and increase the likelihood that Eurobonds happen sooner than anyone thought, or they face the risk of being shut out of the bond market entirely if they go it alone.

This plan would be a landmark event in the crisis in Europe because it's the only one that attempts to address the root of the European sovereign debt issue—the fact that fiscal policies are not integrated across member countries. Europe currently has integrated monetary policy but not integrated fiscal policy; this lack of integration is fine when things are going well. However, during periods of severe market stress like we're experiencing today, having an uncoordinated monetary and fiscal policy is completely ineffective.

This almost makes me want to open a bottle of German beer or grab a glass of French wine to celebrate.

Time to move on to my third, and final, plan in the investment war against our markets called, "Operation Beatles."

The Beatles, an English rock band active throughout the 1960s, was one of the most commercially successful and critically acclaimed acts in the history of popular music. The title of their fifth British album and ninth American album was "Help!" It was also the soundtrack for their film of the same name, "Help!" The most popular song on the album was the hit single titled none other than—you guessed it—"Help!" Are you sensing a theme here? It's called help.

The opening lyrics to this song begin with four simple words: "Help, I need somebody." That's my third, and final, plan for this investment war on our markets: Don't go it alone—get some help from a trusted financial advisor. Now more than ever, due to the complexity of global financial markets, everybody needs the help of a good financial advisor. This just might be the most important plan of all.

Let me bring this commentary to a close with my customary pearls-of-wisdom quote. Just like last week's commentary, the quote is from possibly the greatest statesman ever, and my most admired political leader of all time, Sir Winston Churchill. Here's what Sir Winston Churchill said about the need to have a plan: "It's always wise to look ahead, but difficult to look further than you can see." Hopefully, these commentaries will help you to see how you may be able to win the investment war against our markets. And, most importantly, I hope they help you see that the most important plan in this war is to ask for help from a trusted financial advisor. After that, the only thing left to say is: "Have a great day, keep a positive attitude, and please join me in resolving to remain a long-term investor in a short-term world."

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The views expressed here are those of Dr. Bob Froehlich. Dr. Bob Froehlich's views are not necessarily those of The Hartford and should not be construed as investment advice. They are subject to change. All economic and performance information is historical and does not indicate future results.

Dr. Bob Froehlich's sources of information include Bank of Canada, The Bank of England, Bank of Japan, Bloomberg News, Business Roundtable, China Investment Corporation, CIA. World Fact Book, CNBC, Congressional Budget Office, Deutsche Bank, The European Monetary Union, Federal Reserve Board, The Financial Times, Freddie Mac, FOX Business, Goldman Sachs, International Monetary Fund, International Strategy & Investment, Journal of Commerce, Merrill Lynch, PIERS Global Intelligence Solutions, Strategas Research, Thomson Reuters, Union Bank of Switzerland, U.S. Census Bureau, U.S. Department of Commerce, U.S. Department of Labor, U.S. State Department, U.S. Treasury Department, The Wall Street Journal, and The World Bank.

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All information and representations herein are as of 11/11, unless otherwise noted.

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