Tuesday, December 14, 2010

Merry XMas and a Happy New Year

This is my last blog post for the year as I will be hitting the slopes in Switzerland from this weekend onwards.

In my blog post Finally some good news dated December 1, a day ahead of the last ECB meeting, I wrote: "we are likely to get a timid response by the ECB, just enough to improve sentiment towards risky assets in general in the short term but not enough to provide a real lasting solution."In the meantime the amounts the ECB bought during that period have been published. In the week up to Dec 3, EUR1.965bn of bond purchases have been settled and EUR2.667bn during the last week. While this constitutes a clear pick-up in terms of ECB bond purchases compared to the previous weeks/months, it remains too small and far away from what would be needed to provide more than just a very short term pause in the peripheral's downward spiral.
Given that market liquidity is usually drying up in the period leading to XMas and New Year, theses small ECB purchases seem to have been enough to fuel a short covering rally by some dealers in bonds and even more so in peripheral equity markets where for example the Spanish IBEX was able to rally by more than 10%.
However, the underlying problems for the peripheral economies (an unsustainable debt path coupled with a lack of competitiveness) remain. Additionally, the purchases are not large enough to break the adverse feedback loop. The high yields the peripheral countries have to pay render the debt situation even worse - be it for the sovereign as well as for its banks and corporates/households - leading to higher deficit and slowing down growth even more. Furthermore, given the huge volatility in market yields, sticking to peripheral bond positions becomes more difficult even for investors who think that current spreads adequately reflect fundamental risks. As realised volatility rises, the value-at-risk of the peripheral bond positions increases and hence to keep risks in check, the nominal positions has to be reduced nonethless, leading to even higher yields and higher volatility.
I argued previously that a significant increase in ECB bond purchases could help a lot to break this adverse feedback loop. It would for one lower yields (and with that reduce costs for the sovereigns/its banks/corporates/households) and it could also - if done in a more transparent manner than at present - lower market volatility and hence value-at-risk for investors in respective bonds. Both would help to lure investors back into the market.
However, the ECB seems very reluctant to go down that route and seems to keep its buying as low as possible. This is enough to cause some stability in a thin pre-holiday trading environment, but not enough to get through the funding heavy first months of the new year.
As a result, the peripheral downward spiral remains intact and 2011 promises to see Portugal and then Spain to have to revert to the EFSF before the end of Q2. I expect that at that stage a more lasting solution will be found (probably some kind of E-Bond or bond buying programme, however, judging from recent political rhetoric, it will be called differently). If that would still not happen, then Belgium and later Italy promise to be next.
So, for the time being, enjoy the crisis pause the ECB has provided to celebrate XMas and New Year but get ready for the showdown in 2011!

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