The ECB's XMas Present

I regard the new 3y Tender by the ECB (first one to be conducted this Wednesday and the next one in February) as an extremely positive development. The unlimited fixed-rate tender provides the banks with the option to redeem all or part of the acquired liquidity in 1 years’ time. Hence, banks keep flexibility over their collateral usage. More importantly, the ECB eased collateral standards (ABS down to A rating are eligible as are loans to small and medium sized enterprises).

I see the following main advantages of this tender:
1. During the next year a significant amount of bank bonds will reach maturity (around EUR 800bn). Approximately one quarter of this are government guaranteed bonds which were issued after the Lehman bankruptcy and carried an original maturity of around 3 years. Currently, banks face a very difficult environment to issue bonds (even for covered bonds) and most likely would need to revert to a new scheme of government guarantees. However, in those countries where even the sovereigns face a challenging environment to issue bonds, government guarantees would provide only a limited insurance function. However, as banks can now fund themselves for 3 years at 1%, this ECB tender should go a long way in easing the refinancing burden during 2012. It secures medium-term bank liquidity at a very low rate. Furthermore, it eases the pressure for governments as the likely size of needed government guarantees drops. Hence, via this tender, the liquidity provision for banks via sovereigns is being substituted by the ECB!
2. Banks can fund illiquid SME loans at extremely favourable conditions (1% at present). The drawback though is that the necessary legal paperwork so far has apparently not been finished yet and hence it is not clear whether this applies already for this week’s tender or only for the next one in February. This has several effects. For one, banks don’t need to fund these loans anymore in unsecured markets. Hence, it takes the pressure of unsecured funding markets. Furthermore, it increases the positive carry of the bank loan book as funding costs drop sharply. Finally, it frees higher-quality collateral which banks can use for other secured transactions.
3. The refinancing costs for Eurozone banks should fall sharply (as they fund an increasing part of their balance sheet at 1%). This increases realized margins and should help to restore equity over time, improving bank solvability.

I am convinced that the easing of banks’ funding pain is also behind the improvement in the short-end dynamics of the Eurozone periphery over the past week. Especially for small and midsized banks which a) are not part of the EBAs Stress Tests and b) hold large shares of SME loans, this tender should significantly reduce the need to deleverage and on the margin improve the demand for (domestic) government bonds, especially those that trade above 1% yields and mature in around 1-3 years.
Overall, I expect the two tenders to result in a very large take-up by Eurozone banks. However, it is likely that the February tender will be significantly larger given that so far the necessary legal paperwork for accepting bank loans seems not to be finalised yet. However, I do not think that this action is enough to break the adverse feedback loop and the real test will happen from around mid-January onwards, when the sovereign funding spree starts in earnest.


I wish all my readers a happy festive season and a good start for 2012!

Financial Repression

I have been advocating that the ECB should be buying peripheral government bonds for quite some time (see Monetary easing in the wrong places or will the real ECB please stand up? dated 17 November 2010), however, that does not seem to be forthcoming. I have co-authored a research piece which proposes a different solution. It is based on the following:

1. There are no good solutions left

2. We are in the midst of a devastating debt-deflation spiral. While such a downward spiral starts with an insolvent borrower (in our case Greece) it also affects solvent borrowers and via the negative feedback loop (higher yields = higher deficit/lower growth = lower solvability = lower rating =higher yields) it ultimately destroys even the healthiest borrower (for every frequent borrower, there is a level of yield which it can not afford for a prolonged period of time).

3. What directly follows from the above is that we are in a state of multiple equilibria. One equilibria is the one where we are headed to now which will destroy all the sovereign borrowers of the Eurozone/the Euro. Another equilibria is if government bond yields can be lowered enough to restore fiscal solvability (via lower yields) and improve Eurozone bank balance sheets (via higher prices for government bonds).

4. Hence we need to find a very large buyer for Eurozone government bonds. If the ECB does not want to buy and the EFSF is not large enough (and remember as the EFSF has no banking licence, hence it needs to issue bonds itself to get cash before it can buy government bonds in the secondary market), then our solution is to use financial repression. More specifically, we would force banks to substantially increase their liquidity buffers over the next four years with only Eurozone public sector exposure allowed in this liquidity buffer. 

If complemented by a stability union, the prevention of further voluntary/forced haircuts on government bonds as well as the exclusion of Eurozone government bonds from further stress tests by the EBA then we are convinced that this will be able to break the debt-deflation spiral.

The publication can be found here:
English: Enhanced Liquidity Buffer Framework
Deutsch: Rahmenvereinbarung über erhöhte Liquiditätspuffer

A fundamentally more dovish ECB

I have to admit that I did not expect the ECB to cut rates already at today's meeting as I thought the governing council would not deviate from its script it has followed over the past 12 years.
So far the ECB has always set the repo rate for the average of the Eurozone, i.e depending on the outlook for inflation and growth for all of the Eurozone. Additionally, they never cut the repo rate when the nominal growth rate of the Eurozone was still so much above the repo rate as it is now. At the start of the cutting cycle in 2001, the spread between nominal growth (for the previous 12 months) and the repo rate was almost 0 and in 2008 it was negative. Currently, nominal growth is running significantly above the repo rate (+3% yoy up to June 2011). Even assuming zero real growth in both Q3 and Q4, nominal growth only drops to 2,1% by year end. Besides, the repo rate is currently already at low levels.

Nominal Growth vs. ECB Repo Rate: Spot the difference

 

Source: Bloomberg, ResearchAhead

However, while having been wrong with the repo rate cut forecast, I think it will facilitate the rebalancing process within the Eurozone. In those countries where the credit creation process/the monetary transmission mechanism is working (i.e. those without a sovereign debt/banking crisis), the lower repo rate will support domestic growth. The countries are in the North-Eastern part of the Eurozone, most notably Germany, and have been growing at a healthy rate already. The lower repo rate pressures real yields even lower from already historically low levels. With that it will support domestic investment and pressure the savings ratio lower. Furthermore, with wage pressures already building in Germany, inflation should also stay above 2% over the medium term. A stronger domestic German economy supports the overall Eurozone economy while a higher German price level renders it easier for the periphery to regain competitiveness.

Overall, the ECB seems to have moved towards a fundamentally more dovish interpretation of its mandate which threatens price stability in the "strong" Eurozone countries but at the same time helps to restore internal balance in the Eurozone. I stick to my long held multi-year bullish view on the German economy which has just received additional support.

Underwhelmed?

The European politicians have delivered yet another package to break the Eurozone sovereign debt and banking crisis. Having read a few reports by the sell-side I get the impression that in general there is some relief that the  politicians managed to get a deal done but besides that the analyst community does not see that the low point in the crisis has been reached already. Reasons given are that the plan lacks details, does not solve the sovability issues on the table and essentially largely kicks the can down the road again.
Personally, I beg to differ. First, it was clear from the start that the plan would lack details (what else could one have expected?), but this does not make it any worse. Yes, uncertainty surrounding the Greek PSI deal as well as the likely success of the changes in the EFSF will prevail and yes, we are likely to get more bad news from several Eurozone countries/banks. However, a voluntary Greek solution is far better than a hard default would have been and given the bank recapitalisation scheme should not threaten the banking system. Furthermore, The ECB provides unlimited term funding (with the 13m tender in December lasting into 2013), engages in a new covered bonds buying programme to kickstart primary market issuance and some Eurozone countries will likely reintroduce state guarantess for new bank bonds. Additionally, the new EFSF wil be able to insure new issuance by Italy, Spain and Belgium for about the next three years (if it has to insure all new issuance). This drastically reduces the risk of a buyers strike for these countries. Given that all three countries at current yields do not suffer from insolvency but rather from the risk of illiquidity, these measures - together with the ability of the ECB to continue buying bonds in the secondary market - have the ability to break the sovereign debt-deflation spiral. In turn, this would also provide some relief for the asset side of the banking system.
Overall, I see a substantial probability that (on the assumption the ECB can continue with its SMP and Italy adheres to the promised structural reforms) the joint Eurozone sovereign debt and banking crisis has reached a tipping point. With that the markets should turn their focus away from a systemic financial crisis and move towards a focus on growth and inflation. Here the news out of the US remains constructive and I also expect the Asian central banks to take their foot from the brake as inflation slows down markedly over the next 3-6 months. In the Eurozone, the risk of a wave of state and banking defaults has been reduced drastically (as states and banks are being kept liquid) but the price will be more austerity/structural reforms and hence weak growth in the affected countries. Italy and Spain promise to be in recession in 2012 and I expect French growth to be weak (albeit above 0%). However, I remain optimistic for the German economy given that German corporates should continue to gain market share in world markets and the domestic German economy should see an increasing contribution to growth amid high employment, increasing wage pressures and record low real interest rates. As a result, overall Eurozone growth should be relatively low but positive and I do not see a Eurozone recession. In this environment, I expect the ECB to continue with its liquidity provision measures and SMP buying. However, I do not expect the ECB to cut rates anytime soon.

Are there any optimists left?

First a sorry for having been inactive over the past weeks, I just had a lot going on but I really hope to write again more frequently.

Here is a brief summary of my current thinking. In short, I am not as negative as the prevailing sentiment and recent price action implies. I rather think that over a time period of a few months we will have an improving state of affairs:
a) Recession risk in the US slowly drops. Monetary policy in the US has turned highly accommodative amid record low/negative real yields and an ongoing high level of liquidity. Fiscal policy promises to be roughly neutral to slightly positive for growth. Additionally, the drag on growth from construction activity has passed. Finally, lower inflation (amid lower commodity prices) means that households have more spending power again despite weak wage growth. Overall US growth should be around 1.5% for the next quarters.
b) Emerging markets central banks will move from policy tightening to policy easing amid lower inflation risks. Most emerging markets are in a normal business cycle. Growth was high, fuelling inflation and with that the central banks tighten monetary policy to slow growth and tame inflation. However, as commodity prices have peaked during spring and have receded since, inflation rates should start to drop significantly soon given that energy and food play a significant role in emerging markets' consumption baskets. This should improve growth prospects again and helped developed market exports.
c) Eurozone growth will be significantly weaker than has been the case over recent quarters amid recession in Italy, Spain, Portugal, Greece and very weak growth in France. Germany will continue to do relatively well (approx. 2,5% real growth). However, I do not see a wave of sovereign and/or bank defaults.
First, I expect Italy to move into a recession. Italian treend growth has been low over the past decade (only around 1%). Low trend growth combined with significant fiscal tightening, high real yields (10y BTPei real yields are trading above 4.5%) and a banking sector which amid the sharp reduciton in market value and limited access to funding markets will likely tighten credit availability for corporates and households is very likely to drive growth into negative territory. In the case of France, some fiscal tightening coupled with a high dependency on weak economies such as Italy and Spain as well as the hit to the banking sector will result in weak but positive growth. For Germany, however, I expect that exports to non-Eurozone countries will remain strong (Germany should continue to gain market share in international markets) while domestic consumption should become a growth driver again as inflation eases (thereby fuelling real wage gains) and also construction should be strong amid record low real yields. Overall, Eurozone growth should come in around 1%.
More importantly, though, I do not expect a systemic financial crisis and no wave of sovereign and/or bank defaults. First, countries such as Italy and Spain are being kept liquid by the ECB's bond buying measures while Portugal and Ireland remain liquid amid their bail-out programmes. The banks are kept liquid via the ECB as well (unlimited term funding and now also 3m USD loans) and as announced yesterday the government-guaranteed bond funding programme will most likely be prolonged. With respect to Greece, I expect that the EFSF overhaul will be ratified by the national parliaments and the Greek bond swap will go ahead (even if the participation rate is below 90%). Once that happens, the  threat of an immediate Greek default recedes significantly. One should not forget that the funding needs of Greece post the bond-swap will be very low. First, there will be almost no bond redemptions and additionally coupon payments should drop given that the interest rate Greece has to pay on the new bonds and the bail-out loans are lower than on the outstanting GGBs on average. Finally, if Greece really goes ahead with the privatisation programme, they can cover a large share of the remaining fiscal deficit/bond redemptions. Hence, the quarterly review by the Troika will lose in importance as the sums involved to be paid under the bail-out programme will drop sharply next year.

Overall, this constitutes a relatively upbeat outlook, especially in the light of the pricing action in recent weeks and should be met with higher equity markets and higher Bund yields over the longer term. Near-term, volatility promises to remain high. From a technical perspective, the German Dax has finally broken through its steep downward trendline on a closing basis yesterday (also the US Nasdaq) and starts to emit bullish signals. 10y Bund yields (and the Bund future) are trying to break a 6-weeks steep downward trend and should they close above 2% send a strong bond-bearish signal as well.

Turning Japanese?

This week has seen significant action by the major global central banks. For one the ECB has started buying Spanish and Italian government bonds while the Fed has stated that the funds rate will stay exceptionally low for at least the next two years (Not to forget that the BoJ and the SNB are also injecting liquidity into the financial system to keep their currencies from appreciating ever further).
What are the implications?
1. Banks have already been backstopped since 2008 via liquidity/capital injections/guarantees. This will continue and keep the banking sector afloat. The same now counts as well for the Eurozone sovereigns. Some of the peripherals might technically be insolvent, however, they are all kept liquid by either the EFSF (Greece, Ireland, Portugal) or the ECB as in the case of Italy and Spain (and potentially other sovereigns). Hence, a wave of sovereign defaults is also off the table. In turn, another systemic financial crisis can be called off (at least for now).
2. Nominal bond yields are turning Japanese. As the Fed depresses UST yields and the ECB caps Eurozone peripheral yields, spread products should come back into investors focus. Reasons are that there is no other way to earn yield (given that 5y UST trade below 1%) and as mentioned above the risk of another systemic financial crisis has dropped sharply given the ECB's capping of Italian bonds. Furthermore, the liquidity injections by the ECB, SNB and BoJ (and potentially also the BoE at a later stage) will also fuel the demand for spread products.
3. However, while nominal bond yields are turning Japanese (Low across the maturity and credit spectrum), below the surface the story is vastly different. In Japan nominal bond yields are low because of negative inflation whereas real yields are positive. In contrast, US nominal bond yields are low due to negative real yields coupled with moderate inflation. As an example: 5y Japanese yields are trading around 0,35% with 5y real yields trading around +0,65%, meaning that implied break-even inflation is around -0,3%. In the US, though, 5y UST trade around 0,95% with 5y TII real yields at -0,76% and the implied break-even inflation rate at 1.75%. Hence, the monetary stance in the US is very accommodative on an absolute as well as on a relative basis compared to Japan. In turn, even though the US economy will continue to deleverage over the next few years and with that there will be little self-sustaining growth (personally I think trend growth in the US should have fallen to around 2% and actual quarterly growth number should oscillate around this trend). However, this extreme level of accommodation should prevent the US economy from falling into another recession and from deflation becoming entrenched. Finally, it supports the notion made above: negative real yields will force investors to bring their money elsewhere).

Markit iTraxx Europe Crossover Index: Recent widening likely to reverse again

Source: Bloomberg

Overall, spread products should be the clear winner of the latest policy actions and I expect that the recent widening seen in the credit world will start to reverse again.

From Systemic Crisis to Global Recession?

Despite the ECB having started to buy Italian and Spanish government bonds, financial markets remain in panic mode. However, the key driver now seems to be rather the threat of another global recession than of another systemic financial crisis. On the one side, growth is weak in the developed world where the sovereign debt crisis forces the weaker countries into austerity measures and prevents the stronger ones from adopting significant fiscal easing programs. On the other, the emerging market countries are still suffering from high inflation rates and have enacted monetary tightening measures to cool the economy and ease inflation pressures, hence they can't yet ride to the rescue as well. In turn, markets are pricing a renewed global recession, sending equity markets, commodities and safe government bond yields sharply lower in turn (with the notable exception of gold).
Looking ahead, it seems that in the developed world only the central banks are left to do the heavy lifting. The BoJ has already intervened to weaken the Yen and also the SNB is injecting more liquidity into the domestic financial market. Additionally, also the ECB is providing longer-term liquidity to the banking sector again. Finally, it seems that over the next few months, both the US Fed as well as the BoE might well do another round of quantitative easing. Overall, this creates another global liquidity glut to support asset prices. Furthermore, as the global banking sector is being backstopped via the massive liquidity injections and also the weaker Eurozone sovereigns are being kept afloat via the bail-out programs and the ECB bond buying, the risk of another systemic financial crisis due to a wave of sovereign and bank defaults should be reduced.
In turn, near-term growth in the developed market world should take a hit (personally, though, I do not see another wide-spread recession). However, also inflation should fall markedly given that the ongoing deleveraging should keep core inflation rates suppressed whereas the implosion in commodity prices should lead headline inflation markedly lower (this in turn should see emerging markets starting to ease policy again before the year is over). Hence, near-term nominal growth rates should be very low. Furthermore, given that the banking sector as well as sovereign are being kept afloat and given that available liquidity should be abundant, volatility should drop markedly again and nominal bond yields should be low not only for the safe governments (such as Germany, US, Switzerland) but pressure towards lower yields should intensify again for the wider government bond segment.