2nd December 2011 by Shaun Richards
Today has opened with yet more talk of a potential Euro zone agreement. How many times is that now in the last eighteen months we have been promised this? One matter did really catch my attention and that was French President Nicholas Sarkoky promising to tell the French people “the truth” in his speech at Toulon last night! At one point he even did do this when he said.
There can’t be a single currency without economies heading toward more convergence.If living standards, productivity, and competitiveness gaps widen among euro-zone countries, the euro will sooner rather than later be too strong for some and too weak for others, and the euro zone will explode.
If you change that to a description of what has happened then he was quite near to the truth for once!
In essence President Sarzoky’s proposed solution involves more EU control over individual countries fiscal policies and some treaty changes. Both would take some time to have effect and the problem with that is that they would take a fair bit of time which is exactly what the Euro zone does not have. So we are back to the theme of politicians being well behind events and that assumes that he can actually get support for these measures.
Hopes of Action from the European Central Bank
In the speech I quoted from yesterday from the head of the ECB Mario Draghi there was also this.
A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.
This is being translated as implying that the European Central Bank would be more aggressive with its monetary policy such as buying of peripheral Euro zone bonds if there was more fiscal union. Accordingly markets have taken it well. If they stopped and thought for a moment they would realise that Mario has just described an ordinary country and its relationship with its central bank! Put another way it is a deep implied criticism of the original construction of the Euro zone.
So if we get fiscal union the ECB will buy the bonds which of course will be Euro bonds which it would not mind buying anyway! I think it is best just to say that we are a very long way away from anything like that. As an example of how far from reality European leaders and officials can be Mario Draghi also said this.
notable progress has been achieved in reinforcing economic governance (in the Euro zone).
The International Monetary Fund joins in too
The Managing Director of the IMF has joined in too with the hype and bombast. According to Bloomberg she said this.
If circumstances require, the G-20 will commit the resources that are necessary for the IMF to play its systemic role……That gives you a range that is almost without a cap, without a limitation.
Whilst we mull over what “almost without a cap” actually means (and frankly it means it has a cap) we see yet again promises without substance. As we stand the majority of countries including the United States and China have not fully ratified the last IMF expansion plan and in the case of the US there appears to be little chance of it happening. Yet apparently they will be willing to sign the IMF a blank cheque if Madame Lagarde requests it.
What has really changed sentiment?
This has been driven by the action of the 6 central banks that I described yesterday and in particular the fact that on competitive terms European banks have now a supply of US dollars that is unlimited. This has been something of a game changer and has brought back into play a trade which happened a year or two ago.
Round Tripping government bonds at the ECB
What has also recently happened is that the ECB is back offering long-term liquidity. Now if you can get cash from the ECB at 1.25% now and possibly less next week some government bond yields are looking very attractive. For example on Tuesday night the two-year Spanish govenrment bond yield closed at 5.6%. So you buy an asset which pays you 5.6% and you pay 1.25% for the money making you 4.35%! I am exaggerating the gain slightly as there will be some margin or haircut for doing this from the ECB but even so there are clear gains.
Why was this not happening before? Mostly because fear of contagion as for example in Greece even short-term bonds fell heavily in price and capital losses outweighed the gain in interest. Also the ECB had stopped its one year repo operations which are one part of this but a bit like Jack Nicholson in the film the Shining they are back shouting “Here’s Johnny!”
Now with one of the main fears for the European banking system being reduced ( a shortage of US dollars) it is my opinion that banks are being bolder and are willing to buy government bonds and round-trip them to the ECB for a profit. So we are now seeing rallies in such government bond markets which at least partly are being driven by this move.
Perhaps a clearer signal of this might be found in Italy where the two-year bond yield was 7.1% at Tuesday’s close (before the central bank action) so here there were larger profits available of up to 5.85%. Now “Italian risk” is also higher but with her banks having some sort of a backstop from the US Federal reserve suddenly a return like this looks attractive.
In this article I have compared two year government bond yields with a one year ECB operation so there is some maturity mis-match and some risk from this. But in the end all investment decisions are risk versus reward and pure arbitrages are incredibly rare, although there are a few bonds about which will be for a term of a year.
Will this ripple through the bond markets of the Euro zone?
Yes it will and if we add in the fact that the change in the banking risk in Europe due to the central bank action will also create a few genuine bond buyers too we can see how prices have risen and yields fallen. In some of these markets buyers will be like rain in a desert as virtually the only buyer recently was the ECB.
If we add in both effects we see an Italian government bond market which has rallied substantially on this news. Her ten year bond yield has fallen by nearly 0.75% since the announcement and is now 6.5%. Other markets have improved too but even this news has not done much good for Greece and Portugal ( which reinforces my theory as their bonds no longer fulfil the ECB’s repo criteria).
Central Banks have created a false market
You may have spotted that rather than directly supporting government bond markets the ECB is indirectly supporting them with the help of a backstop from the US Federal Reserve. If a private organisation tried to do this it would be prosecuted. Remember the Hunt brothers in the silver market?
Is this yet another free lunch for bankers?
In many ways yes. If this works they declare a profit and then tell us how clever they are and pay themselves bonuses. On the other side of the coin their bank may well have failed or been in trouble so where is the loss for them? At the limit they may have little or no downside in a “too big to fail” world.
Meanwhile the taxpayer ( in the first instance in the Euro zone, in the second in the United States) is supplying them with the cheap money allowing them to make a profit out of other taxpayers issuing bonds. Shameful really.
The intervention by central banks looks like it has been a game changer for now. Certainly equity markets have loved the move as they have surged all week (did it leak?) and the UK FTSE 100 is up 90 points at 5578 this morning alone. However we return to a familiar theme which is that yet again liquidity is no solution to a solvency crisis even if lots of it is provided but the problem may be masked for a while.
As an aside I would also like to point out that for an ordinary investor markets have become virtualy untradeable and in my opinion all this central bank intervention has made them the “casino” that they were criticised as being in the past. An investor who vested his pension on Friday for example would now be ruing the fact that the equity component is now 8% higher than then. How could he or she have rationally forecast that?
No doubt the political hype and bombast will continue and I notice that there will be yet more summit inflation in the Euro zone next week. However so far the record of politicians when central banks have bought them some time has been shocking and so we seem to be entering another phase where if you are a holder of peripheral Euro zone government bonds you are being given an opportunity to exit your position paid for by their taxpayers.
Meanwhile signs of trouble continue to mount in the background. Overnight European banks have borrowed some 8.6 billion Euros from the ECB’s overnight emergency facility and at the same time banks have deposited some 313.8 billion euros with the ECB. So the central bank is well on its way to being a transmission mechanism replacing what used to be called the interbank market. Remember this is with all the central bank intervention.