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!
