Wednesday 21 December 2011

Euphoria in Eurozone

Euroland euphoria on Mario Draghi bank rescue
Southern Europe's battered debt markets are basking in a glorious pre-Christmas rally as hedge funds and investors celebrate a blast of cheap liquidity from the European Central Bank.

20 December, 2011

Yields on Spain's three-month notes plummeted to 1.74pc on Tuesday from 5.11pc last month, leading euphoric moves across the eurozone periphery. Spanish 10-year yields fell below 5pc for the first time in two months, with credit rallies in Italy, Belgium, and Ireland.

Exuberance lifted Germany's DAX index by 3pc, the French CAC by 2.7pc, and FTSE 100 by 1pc, with ripple effects through commodities and risky assets worldwide.

The buying spree comes as markets wait for the ECB to turn on the monetary spigot. Funds are betting that an offer of unlimited bank credit for three years – long-term repo operations (LTROs) – will transform the underlying dynamic of Europe's debt crisis. Banks will be able to borrow at 1pc to buy Spanish and Italian bonds at 5pc or 6pc. It allows the ECB to prop up sovereign states without violating EU treaty law.

Lenders call it the "Sarko trade" after French leader Nicolas Sarkozy said the liquidity will allow each state to "turn to its banks" for finance. Markets have seized on the idea, hoovering up distressed debt in advance to lock in gains.

The ECB move is part of a string of fresh measures by the bank's new president Mario Draghi to head off a dangerous escalation of the crisis. "We are trying to avoid a credit crunch," he told Euro MPs on Monday, warning that EMU banks and states must together to raise €720bn (£602bn) over the first quarter of 2012.
This subtle form of 'credit-easing' includes a cut in the reserve requirement to free up €100bn in lending power, and looser rules to allow collateral-starved banks to pawn more of their loan books at the Frankfurt lending window.

"Draghi's been smart," said Simon Ward, of Henderson Global Investors. "The spread available to banks is going to prove attractive. He has outmanoeuvred the Bundesbank by drawing it in deeper."

Yet it is unclear whether liquidity alone can stop investor flight from Club Med. European banks have already cut holdings of EMU bonds by €65bn this year, and are slashing loan books to meet the EU's core Tier 1 capital ratio of 9pc. The Basel-based Global Stability Board fears that deleveraging could reach €2.5 trillion over coming months, risking a shock to the system.

"This may help sovereign debt a bit but we don't think it is a game-changer," said Mark Schofield, rates chief at Citigroup, predicting that banks will use the money to plug other holes and cover a dollar funding squeeze. "Most banks already hold too much of their own government's debt. It may take coercion to make them buy more."

Jacques Cailloux from RBS said over-excited markets may latch on to a big headline number at today's tender – perhaps €500bn – but most of this will be recycled money from old support operations. "The new liquidity will be just €100bn or €200bn. This at least prevents a Lehman event in the banking system but it doesn't solve the fundamental problem," he said.

There are nagging concerns over how long the ECB itself can keep shouldering the eurozone burden, given that it has no sovereign entity behind it. The three-year LTRO is like a 'double-up' Martingale bet. It may save the day but it also concentrates risk further for the Bundesbank and other central banks in the eurozone system, as well as private banks.

The ultimate disaster could be even worse if it all goes wrong.

Away from moves driven by the ECB's actions, stockmarkets were also buoyed by an unexpected boost to Germany's economic outlook. Despite a gloomy forecast earlier this month, the respected Ifo Institute said its latest monthy index showed business confidence had increased to 107.2 points from 106.6.

Respondents told Ifo that while the current situation was bleak, they expected the economy to improve over the next six months. Economists had expected confidence to fall. Hans-Werner Sinn, president of Ifo, said: "The German economy seems to be successfully countering the downturn in Western Europe." German consumer confidence was also up, according to GfK data.

There was less optimism across the border. Jean-Pierre Jouyet, head of France's AMF securities regulator, admitted it was unlikely his country would keep its AAA rating. He said: "Keeping it would need a miracle but I want to believe it can happen."

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