The liquidity injected into the banks through various mechanisms appears to have calmed the risk markets in 2012 (all of one month old). Recall, the ECB has provided nearly €500bn of repo funds under the LTRO scheme. The unlimited Fed swap lines transform Euros into USD which allows banks to continue funding their USD assets. It is hoped that Banks, flush with liquidity, will be impelled to buy Sovereign Bonds and capture the (still) material “carry” with the added comfort that politicians and central bankers will not let the major Eurozone Sovereigns collapse. The ECB recently revealed that their balance sheet expanded to nearly €3 trillion demonstrating their commitment to keep the juice flowing– not bad for a central bank that refuses to print.

The effect has been clear to see this month. Italian two year bond yields (chart 1) have fallen to 3.15% from 7% at the end of November 2011. Itraxx Cross-Over Index (CDS spreads on 50 junk rated European Corporates) has fallen to 600bps p.a. from 850 bps p.a. (Chart 2). European Stock Markets hit a six month high yesterday. Even Portugal, widely believed to be the next Greece, has seen its bond yields drop by 2-3% as hedge funds attempt to lock in the wide spread through the infamous negative basis trade (buy bonds at say 20% p.a. and buy CDS protection at 14% p.a., theoretically lock in 6% p.a.). As for Greece, well, the restructuring resolution is imminent (as it has been for more than two weeks now).

With about 25% of the European Sovereign funding calendar successfully completed, a potential ECB rate cut next week followed by another window for Banks to stuff their pockets with LTRO funds at the end of February, the authorities appear to have “solved” the immediate issue of confidence in the Eurozone (and given themselves a fighting chance to fund the balance of Italy and Spain’s refinancing needs). Helped by the US Federal Reserve’s promise to hold rates down till 2014 and beyond, the palpable fear that was evident in the markets late last year has transformed into a euphoric panic amongst asset managers, hedge funds and banks not wanting to miss out on the “low hanging fruit” being dangled.

Wall Street certainly knows how to have a great party with €3 trillion in the kitty. But, what about “Main street”?

Unemployment levels in Europe are at all time highs (see FT chart below). The level of pessimism amongst the educated unemployed is at its highest (Gallup). These youth are considered most likely to leave and find opportunities elsewhere. Spaniards are moving to Argentina, the Portuguese to Brazil & Angola and the Greeks to Germany (there is an irony there somewhere). A mass exodus of educated human capital will have long term implications to the growth prospects of these nations. In order to become competitive (and without the ability to devalue the Euro) these countries will either have to import workers or export production to emerging countries. None of this is likely to be politically palatable to those who remain. Once the dust settles on this liquidity induced rally, the markets will once again start paying attention to the real cost of this crisis. But for now, we party!

The amnesiac pixy dust sprinkled by the central banks over the year end had barely started to work when the two headed “fly in the ointment” - S&P decided to gate-crash the party. The fact that they chose Friday, January 13 to downgrade several European Sovereigns is ironic. Until then, markets had been kept buoyant without any major bad news (Europe was on holiday until the 2nd week of January) and moderately successful Italian and Spanish auctions. The downgrade of France, Italy and Spain will ultimately have a negative impact on the rating of the leveraged CDO we fondly know as the EFSF. Whether rating will drive the funding costs wider, we shall have to wait and see. The political response from the EU to the downgrades by S&P has been swift and scathing. In a speech, Ms Merkel confessed she would consider legislation to bar institutional investors from selling bonds when ratings were downgraded, or fell below investment grade. Comforting news – you can buy, but can never sell!  

The timing of the Italian three-year bond auction was interesting, if it transpires that Italy knew of its two notch downgrade, but chose not to share this material information with investors. They may have figured that since buyers were Italian banks, who have in turn been funded by the Sovereign anyway, there is no risk of litigation. After all, family is everything. Whilst the buying action was in the short end, the long end of the Italian bond market is under pressure after LCH hiked initial margins (again, having lowered margins just a few weeks ago) to 18% on the 15-30 year duration bonds and 8.30% on the 7-10 year. The Italian curve will get steeper as the long end is sold off to satisfy margin calls and funds flow into the LTRO inspired three-year (and less) maturities. The ECB is also reputed to be buying BTP’s around the Bunds + 500 bps level.    

Meanwhile, the Greek restructuring saga continues with investors fighting to avoid substantial write-offs, especially in light of the reprieve provided to investors of all other Euro-zone debt. Recall that much of the secondary Greek Government Bonds (GGBs) have recently been snapped up by activist hedge funds who will not play by the rules. To counter this threat, the Greeks (or their puppeteer, Germany) have unveiled their secret weapon – the Collective Action Clauses (CAC) that can retrospectively cram majority decisions onto the rebel minority. But what if the minority are now the majority?  

Further, only private investors are in line to take a haircut and the ECB is off the hook for its €50bn+ of GGB purchases. This structural subordination will have longer term repercussions for funding the Euro-zone. Many investors would refuse to participate or demand higher yields, which in turn will keep the cost of funding for the peripheral nations prohibitively high.   

As I write, the market is looking to shrug off the downgrades as “old news” and as “news already priced into the market”. Stock markets are stabilising and Wall Street rhetoric is telling us that the “surprise” could be to the upside in 2012. The plumbing of the financial system – funding – appears to be secure and tightening bank CDS spreads (see chart below) simply that the risks of a major default are receding.   

A wise man once told me that people only want to see the value of things they own go up – even if it’s an optical illusion. The sell side of Wall Street remains the greatest illusionist of them all. Watch out for under-invested funds and the retail investor getting sucked into the bullish whirlpool, before the illusion is revealed for what it is. As we have witnessed in the past: receding waves can often be a warning sign of a building Tsunami wave.

Following the long-term refinancing operation (LTRO) of €489bn, there was a bated sense of anticipation that banks will binge on their national sovereign bonds, earning "carry" to boost profits. Net of refinancing due by the banks in 2012, it is expected that around €210bn of net new funding is available. Assuming the average sovereign issuance is at 5% and funding is 1%, there is a maximum potential for annual carry profits of €8bn per year or €24bn over 3 years.  Given that banks have to raise €115 bn of net new capital by July 2012, the annual €8bn is clearly a drop in the bucket. This partially explains why the bulk of the €210bn surplus (€167bn to be precise) was re-deposited with the European Central Bank (ECB) at rates of 0.25%. So, instead of positive carry from buying sovereign bonds, banks are prepared to earn a negative carry of 0.75% to keep their balance sheet (appear) strong. Perhaps this is simply a year-end effect and banks will bring their cheque books into forthcoming sovereign auctions as quid pro quo for all the liquidity and guarantees they have been provided.

As an example, LTRO requires banks to deposit quality collateral - although the ECB recently relaxed the rule so that even the proverbial kitchen sink could be repo-ed against LTRO.  Even so, it appears that some banks with balance sheets in the € trillions did not have unencumbered assets to pledge.  Some Italian banks, who have in total borrowed around €40bn in the LTRO, have cunningly issued bonds to themselves, had them guaranteed by the Republic and then pledged these with the ECB to LTRO. Not quite cricket, I hear you say, but then this is Europe - they don’t know the rules of cricket (or care for that matter). This is survival.

This should warn us that 2012 is going to be a scary year. In spite of all the liquidity injected into the banks, banks will remain focused on survival and unprepared to lend to main street in a material way. In fact, sovereigns are busy lending to banks who are lending back to the sovereigns. Main Street is not even in the picture. Instead of cash, expect bullish rhetoric from the sell side to keep the market afloat.

Welcome to 2012, the year history books will likely tell us that the ECB officially launched (Quantitative Easing Euro) QEu, the Federal Reserve conducted (Quantitative Easing Three) QE3, the Euro went to Parity, Greece was thrown out and the curtains finally came down on the single Euro-zone experiment.     

Following last week’s fiscal “lite” agreement in Brussels, markets are behaving like a cat with furballs – lots of coughing, gagging and then when you think something really bad will happen, reverting to a sense of eerie calm. With all the liquidity injected into the system, dealer desks anticipate no major bank default in the horizon. That said, they may be “talking their book” and with the headlines in Europe getting worse by day – punitive yields, substantial near term refinancing walls, political bickering, strikes – there is an impending sense of doom and gloom in this usually festive period.

The arithmetic around Europe is not inspiring. If your debt/GDP ratio is close to 100%, your funding costs are 6% and growth is predicted to be zero, then your debt can only go up – not down. If the markets refuse to lend to you or keep charging higher yields, you eventually go bust. The markets pray for Santa to turn up in the guise of the ECB and buy Euro-zone Bonds in size. This would transform default risk into inflation risk and we should see a spike in nominal value of risk assets. After all, inflation has been the chosen vehicle for solving debt crises of most governments since the early 20^th century, ironically coinciding with when the FED was created in 1913. The question you must ask is if the ECB or indeed the FED will come in with further QE at these market levels. Suspect they will wait for much lower levels and a greater sense of panic before they act.

If you believe we are in strange times so far as Europe is concerned, please see the chart below which shows bond yield spreads of the core Euro countries against Germany. Could it be that period 2000- 2008 was the outlier and these are more normal times?

I must be dreaming for it all looks so different or I have just woken up and everything before was a dream?

The ECB and the Eurozone governments have orchestrated a cunning plan that should support markets over the next few months. Last Thursday the ECB declined to buy Sovereign bonds in bulk, and instead delivered some key liquidity measures.  Interest rates were cuts, the collateral haircut was reduced and they agreed to accept a wider range of collateral (“kitchen sinks” may be acceptable).  This would make it easier for European banks to fund over the next 1-3 years.  On Friday a promise of a fiscal union was duly delivered, with potentially 26 of the 27 countries likely to ratify.  The UK has vetoed and left the table; although it is unclear if there was anything to veto in the first instance. More funds were allocated to the various acronyms - IMF, EFSF and ESM - which will support the Eurozone bond prices. The fiscal union should prevent the next crisis and adds a bit of firepower to deal with the current one. 

Even though there is no Bazooka solution, the technicalities of how this rescue might work showed up in a Bloomberg headline late Friday. The EBA (European Banking Authority) announced that BNP Paribas had sold $2bn of credit default swaps on France.  You may wonder who in their right mind would buy CDS protection on France from France’s largest bank. Surely if France were to default, the bank would default and the credit protection would not be worth the paper on which it’s written.  However, there are plenty of banks  that would participate on the other side of the BNP trade. Two theories abound as to BNP’s motives; the first is that banks are selling down their sovereign exposure and their related hedges, which would mean selling bonds and selling the previously bought CDS protection.  This could be driven by banks selling their Bond / CDS packages once they realized their bonds can be restructured without triggering CDS protection (as evident in the Greek restructuring).

The second, more likely, reason is that the “all or nothing” trade is back in vogue.  Banks can earn high Sovereign CDS premiums available by selling protection on their sovereigns.  If things go well, as the banks and governments will hope, spreads will tighten and they will make profits.  If sovereign spreads widen, it’s likely the banks’ credit spreads will widen further.  As such, the PV of the mark to market is unlikely to look too bad.  In the worst case, the banks will default; in which case the traders don’t really care anyway.   The regulators have given France a 0% risk weighting, so selling CDS on the sovereign does not require any regulatory capital.  It is possible as spreads widen they may have to post margin calls or take mark to market losses.  However, the cost of funds for banks (from the ECB) has been reduced to just 1%, and is expected to fall further.  There are similar stories of Italian Banks selling CDS protection to Italy.  As it stands, Italian Banks can currently borrow funds at 1% and buy five year Italian Bonds yielding almost 7%.  Risk On!

This is a roundabout way for convincing banks there is money in the “Carry Trade”. Borrow cheaply from the ECB and buy Sovereign Bonds and lock in the spread.  This could also explain why the ECB (for now) has resisted the idea of being the lender of last resort to sovereigns.  The reasoning must be that there is another leg to the panic (sometime next year) and they can preserve some of their options to tackle then. There is, however, no long term solution except to cut debt and shrink the economies. This is medicine that no politician can prescribe, so it will have to be left for the “invisible hand” of Adam Smith to do the job. 

Meanwhile, we have yet another crunch meeting on December 9 to “finally resolve” the Euro-zone crisis.  The proposal on the table is “fiscal union”, which essentially means that the Bundestag will analyse a country’s budget before its own parliament gets to vote on it. Ireland had a sneak preview this week of how this might work. The belief is that with a fiscal union in agreement, the ECB will bring out its bazookas to buy all sovereign debt and keep yields in check. Essentially, this means the ECB will print money like the US, Japan, Britain and China already does.

Interestingly, one of the proposals agreed during the Merkozy summit yesterday (December 5) was the decision not to “force” private sector bondholders to take any further write-downs on future sovereign bailouts. Two things come to mind; first, bondholders may still “volunteer” to take a haircut (visualize the scene from the Godfather when an offer “you cannot refuse” is made) and second, guaranteeing all sovereign debt was actually what blew up Ireland (Read Michael Lewis’s recent book, Boomerang). One of these days people might just figure out that cheapening the cost of funding is no solution to a problem of solvency. But for now, we party. 

Although it’s not over until the fat lady sings (in this instance, a rendition of Wagner’s Wedding March might be appropriate), we have come a long way from the days of Europe’s leadership blaming “irresponsible, greedy hedge fund traders for targeting (fundamentally sound) Euro debt”. In order to help them focus on finding a solution, the rating agency S&P has placed all the Euro-zone countries on watch for a potential mass downgrade (50% probability that a downgrade will happen in three months). This will certainly dissuade Germany and France to provide further guarantees or funds to the EFSF leveraged scheme (which was heralded as the grand solution all of four weeks ago). Notwithstanding the deep scepticism with which S&P is viewed by Europe’s leaders, it appears justified. Italy alone will have to issue up to a third of the €350bn it needs to raise in 2012, in the first three months.