What is the LTRO going to do for Europe? And how does it affect my stocks?
I think that the essence of this bullish rally can be summarized by this one chart
Investors have taken to the opinion that the long term financing operations (LTRO) provided by the ECB back in December has removed the risk of collapse in Europe from the table, maybe even for a couple years. It’s all clear to buy stocks.
Investors are of the mind that the LTRO has removed the risk of collapse in Europe from the table, maybe even for a couple years.
The ECB’s LTROs have succeeded in breaking the negative spiral of rising risk aversion, poor asset performance and forced selling. Money is cheap, and every day, confidence is building little by little, prompting buying. The resulting asset performance in turn raises confidence further. The lack of street inventory implies small shifts in demand have a much bigger impact on spreads than in the past.
I underestimated the effect of the LTRO. I might have recognized that having a liquidity backstop for the banks would be a big confidence builder for the market. Unfortunately I didn’t. Whether this confidence can be sustained, well that is a question I hope to look at here.
Things came very close to going sideways
We were on the edge of the cliff at the end of November and early December. No where can these be seen more clearly then by the yields of short term bills of the periphery. While I have put up the chart for the 10 year Italian bond a number of times, I have not focused on the short term bills. Below is the rather shocking collapse and then restabilization of the 6 month bill in Italy.
The LTRO coincided with a tremendous drop in short term yields. A lessor, but still significant, drop came in longer term yields. Equities rose as yields fell and the crisis abated.
Is it sustainable?
Citi doesn’t think so. In the same note Citi says that the rally is likely mostly based on fumes. The reason? While QE1 and QE2 stimulated lending (and speculation), the LTRO is not expected to stimulate anything other than bank liquidity.
To put it simply, almost all the big banks in Europe are going through a process of deleveraging. The LTRO simply helps them through this process without putting undue stress on one another, like the stress at the end of November last year.
FT had a good piece on just what the ECB’s intent is for the LTRO. In it they argue that the ECB did not create the LTRO funding to flood the EU with Euros or to stimulate government debt buying by banks. They did it to “stop a heart attack of bank deleveraging in the eurozone.” When the LTRO is understood this way, it can be seen that it is more akin to the Fed’s response to the commercial paper crisis in 2008 than it is any QE.
This is an important point.
Providing liquidity directly to banks for operational use, as the Fed did in 2008, has historically not been much of a prop to equity markets beyond an initial, confidence induced, blip. The Fed did all sorts of operations in the fourth quarter of 2008. It wasn’t until it embarked on a true QE in 2009 that the market actually responded favourably for an extended period.
It makes you wonder what the half life is of the LTRO effect.
What are the mechanisms of transmission?
The problem is that the LTRO is a liquidity mechanism and the problem in Europe is not a liquidity problem. As Mauldin pointed out in that piece I referenced last week, europe has a solvency problem brought on by countries that simply aren’t competitive and banks and sovereigns that are overleveraged. QE begins to solve the solvency problem because newly printed money pays off old, otherwise unpayable debt. But is the LTRO intended, or should it be expected, to do that? I don’t think so. Its just a long term repo, or in other words, long term borrowing for the banks with very little restrictions on the collateral they have to put up in order to get the money.
I think that to speculate on the real effect of the LTRO on equities over the medium run, you have to think about the mechanism by which QE causes the market to rise.
So certainly there is a change in market psyche. QE lifts the spirits of the market. The LTRO did that too. I would attribute the rise in stocks over the last few weeks mostly to this effect.
In our current case, there is probably also an element of pessimism that was no longer warranted. The bank stock in Europe, in particular, had been priced to fail. Failure was no longer imminent, so a rally had to be expected to reprice a degree of solvency back into the stock prices.
Those two elements are probably the biggest effects in the short term. At some point though, they are going to wear off, and the market is going to start asking, so what is this LTRO actually doing? Its this longer term impact where the picture gets fuzzy because I don’t think the LTRO has the same long term effect as QE.
The two main long term (with long term meaning months) effects of a QE program is that the excess money sloshing around from the QE lowers the cost of funding, entice businesses and consumers to borrow, and it provides banks with the liquidity and capital to make more loans.
The problem is, I don’t see that happening here. Banks in Europe are in deleveraging land. Just as would be expected, the evidence is that the banks are taking the money and turning right around to inject it back into short term bills (see that chart of Italian bill rates above). They want liquidity that can be easily accessed in case their wholesale funding dries up. They don’t want to make a 3 year loan to Acme Manufacturers, taking on the associated risk. They already have too much risk on their balance sheet.
This is great for the bill market; rates fall, and it certainly removes the most stressed condition from Q4, but if the money not finding its way into the economy, what good is it going to be for growth?
The Eurozone still isn’t growing much
Back to the Citi note one last time:
Despite a mild winter the European economic data isn’t really improving. Our economists have just lowered their Euro zone growth forecast for 2012 from -1.2% to -1.5%. Spain’s Budget Minister Montoro has just warned the country may miss its 4.4% budget deficit target for 2012. The earnings season has been decidedly mixed, with about 60% of US S&P 500 companies beating to date – much lower than in past quarters.
Access to liquidity just lets banks keep on keeping on for a few more months. Like the Fed operations in 2008, the liquidity injections led to short term spikes but no lasting impact on the market. I am willing to speculate that the LTRO response with follow suit.
Capital Ratios an other impediments
Another FT article, this time referring to Richard Koo of Nomura, speculated similarly. Koo is talking specifically about the impact of the 9% capital ratio, but as he alludes to, there are a number of factors producing the same basic effect on banks: new capital is used to assist in de-leveraging, not growing:
What is preventing the funds supplied by the ECB from flowing into the real economy and improving economic conditions? Although there are a number of answers, the biggest obstacle from a policy perspective is the European Banking Authority’s tough new capital rules.
The EBA has demanded that European banks raise core Tier 1 capital to 9% of risk-weighted assets by June 2012. None of the policies unveiled in response to the crisis has been so counterproductive…This 9% rule effectively prescribes the size of European banks’ balance sheets. This means banks will not be able to increase lending no matter how much liquidity the ECB supplies, effectively rendering any monetary accommodation by the ECB powerless to stimulate the economy. The EBA’s 9% rule may help in preventing the next crisis, but it will do nothing to resolve the current one—in fact, it will make it much worse.
Yields in Portugal aren’t falling
On a related note, one of the most interesting developments over the past month is that the Portugese 10 year yield has NOT fallen.
In the next few months we should start to get a better picture about the impact of the austerity measures on the economies of Greece, Portugal, Italy and Spain. I would speculate the numbers will be grim, and a lot of the wind provided by the LTRO will be knocked from the sails.
Bringing it all back home (to the portfolio moves)
As you know, I continue to hold a couple shorts of European banks. I also added more gold stocks yesterday (specifically ABX and more OGC) after the Fed news so these banks shorts could be seen as a bit of a hedge on my rather large gold stock position.
The other day I was contemplating some of my positions which had begun to move against me. A lot of that has cleared in my head over the last few days. The Fed announcement brought back my conviction in gold stocks. And after taking a long and hard look at Europe, I have decided that I am likely on the right side of this bet, and while I would be wary of adding too much to that bet as the market moves against me, its not time to cut it just because of a few tough weeks.
The biggest thing that I think I have to remain wary of is that the ECB holds the trump card here. A true QE style of bailout in the neighbourhood of E2B to E5B would truly push the problem so far out that it would be someone else’s worry. Today’s announcement by the Fed to keep rates low for much longer than most anticipated could be seen as a step towards that. At the end of the day, realizing that the LTRO is not the QE that everyone seems to be interpreting it as leaves an open question: is the QE still to come?