The best way to protect yourself as the Fed wades into Europe

The Federal Reserve has led central banks in throwing more cheap money at Europe's debt problem. John Stepek explains what happened, and what it means for you.

Is there no problem that can't be solved with the application of some easy money?

Markets around the world rocketed yesterday as the world's central banks got fed up waiting for Europe to do something. The Federal Reserve and the rest of them ganged up for an assault on the forces of bearishness, spraying more cheap money into the system in a concerted effort.

It worked. The Dow Jones index is back in positive territory for the year. The German Dax gained 5%. And the FTSE 100 was up 3%.

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So what exactly happened yesterday? And is this a turning point in the eurozone crisis, or just another false dawn?

What did the Fed do yesterday?

'Easy money Wednesday' started with the Chinese. The central bank relaxed reserve requirements for the first time in nearly three years. In short, it means the nation's banks will be allowed to lend more. This move eased some worries that China is heading for a hard landing, so it gave shares around the world a bit of a boost.

But the real rocket fuel came later in the day, when the Fed announced, along with central banks in Europe, Britain, Japan, Switzerland and Canada, that it was cutting the cost of borrowing dollars for foreign banks.

To explain what this means, we need to return to the eurozone crisis. The problem in the eurozone is not that different to the sub-prime crisis of 2008. We have a group of toxic securities (eurozone debt this time, US mortgages last time) on the loose in the banking system.

No one is entirely sure how toxic these securities are. And they are not quite sure who's holding them. But they don't want to take any chances. So effectively, the whole of the European banking sector has the plague as far as the rest of the world is concerned.

There are two aspects to this problem: solvency, and liquidity. If you are insolvent, you are bankrupt. Even if you sold everything you owned, you still couldn't repay your debts in a timely manner.

Liquidity is a different problem. You can be perfectly solvent, but not have any cash at hand to pay your debts. The problem is, if you can't get hold of any cash to pay your debts, you might end up becoming insolvent.

Banks like any other businesses need a steady supply of cash to perform their every day functions. And global banks need a steady supply of the global currency the US dollar. It's usually easy for them to get hold of this cash. Other banks will happily lend it to them. Or if times are troubled, and you're a US bank, you can get it direct from the Fed.

But if you're a European bank, and no one trusts you, it's harder. You can't get dollars from a US bank, because no one will lend to you. You don't have a hotline to the Fed. And your own central bank doesn't carry enough dollars to lend to you.

So here's what the Fed has done. It has made it cheaper for foreign central banks to 'swap' their own currencies into dollars. They can then lend these dollars to troubled banks in their own regions. (My colleague Tim Bennett will be explaining how all this works in this week's video tutorial - you can watch all of Tim's video tutorials here - I'll leave it to him to give you the gory details).

So to cut a long story short the Fed's move has at least delayed a massive credit crunch in the eurozone. It has solved the liquidity problem for now. Banks now have access to the cash they need, at a rate they can afford to pay.

What the Fed hasn't done and can't do is to deal with the solvency problem. Greece is still bankrupt. Italy and Spain are still on shaky ground. In other words, the toxic assets remain toxic. And Europe's leaders seem no closer to figuring out a solution.

The best insurance against unexpected interventions

In short, this is another method for buying time, but it doesn't solve anything.

We're still waiting to see what the Europeans will do. The head of the European Central Bank (ECB) has yet again ruled out unlimited quantitative easing, saying that any bond purchases by the ECB must be temporary.

Beyond that, it seems hard to believe that the Fed would buy up European bonds instead. The idea that the Fed is now bailing out European banks will already be making various US voters jittery. America printing money to buy eurozone sovereign debt would almost certainly be a step too far.

In any case, just as a reminder, printing money is not the easy way out of this crisis. John Kay sums it up in the FT. "Money created by a central bank is not free The resources of a monetary agency come either directly from taxpayers or indirectly from everyone through general inflation."

So what does all this mean for investors? The point is, regardless of what the markets do on a day-to-day basis, the underlying economic outlook remains ugly. That's why we're sticking with defensives.

As for the best way to protect yourself from unexpected action by politicians and central banks well, that's gold. It jumped by 2% yesterday as investors worried about even more money printing. And as my colleague Dominic Frisby advised earlier this week, there is just too much uncertainty around for you to take the risk of not owning some.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.