More Color on the ECB's 'QE Lite'

A few more words regarding the ECB's latest moves in terms of providing new emergency liquidity facilities are in order. These long term funding facilities are not 'QE' in the sense that they are not permanent. However, they are in essence similar to the arrangements that have been put in place on account of the 2008 crisis, and given the evidence from that time, they should definitely bring about a sizable expansion of the ECB's balance sheet and lead to a notable surge in euro-area money supply. The covered bond purchases appear to be a QE type operation, but the amount of € 40 billion will probably be small compared to the liquidity that is going to be pumped into the banking system via the emergency facilities (note that these are not limited in terms of their size).  Theoretically these liquidity additions have a fixed shelf life – they should eventually be taken back. Undoubtedly this is the plan. Once the crisis has passed, so it is reckoned, the securities the ECB temporarily monetizes will be sold back to the banks.

However, so far all these 'temporary' activities have taken on what appears to be an unintended permanence, as crisis follows upon crisis. The market reaction to the announcement (a continued rally in 'risk assets') meanwhile makes a certain amount of perverse sense – bank funding pressures are relieved, and inflationary effects can be expected as a result of these operations.

Note here that the covered bond purchases, insofar as the bonds are purchased directly from banks, will increase the cash assets (excess reserves held with the ECB) of the banks. Any covered bonds purchased from non-banks will not only increase excess reserves, but also the amount of deposit money in the system (we refer you to our article on the mechanics of QE for details).

Regarding the emergency liquidity facilities (referred to as long term refinancing operations, or LTRO's below),  note that they are in addition to the already existing measures (referred to as 'main refinancing operations' or MRO's below). These new measures therefore represent a significant inflationary push.  Here is the statement of the ECB's governing council in full, with the decisive points emphasized:


“The Governing Council has decided to conduct two longer-term refinancing operations (LTROs), one with a maturity of approximately 12 months in October and the other with a maturity of approximately 13 months in December. The operations will be conducted as fixed rate tender procedures with full allotment. The rate in both operations will be fixed at the average rate of the main refinancing operations (MROs) over the life of the respective LTRO, and interest will be paid when each operation matures. These operations will be conducted in addition to the regular and special-term refinancing operations, which remain unaffected.

The Governing Council has also decided to continue conducting its MROs as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the sixth maintenance period of 2012 on 10 July 2012. This procedure will also remain in use for the Eurosystem’s special-term refinancing operations with a maturity of one maintenance period, which will continue to be conducted for as long as needed, and at least until the end of the sixth maintenance period (i.e. around the end of the second quarter) of 2012. The fixed rate in these special-term refinancing operations will be the same as the MRO rate prevailing at the time.

In addition, the Governing Council has decided to conduct the three-month LTROs to be allotted on 25 January, 29 February, 28 March, 25 April, 30 May and 27 June 2012 as fixed rate tender procedures with full allotment. The rates in these three-month operations will be fixed at the average rate of the MROs over the life of the respective LTRO.

Furthermore, the Governing Council has decided to launch a new covered bond purchase programme (CBPP2). The programme will have the following modalities:

The purchases will be for an intended amount of EUR 40 billion.

The purchases will have the capacity to be conducted in the primary and secondary markets and will be carried out by means of direct purchases.

The purchases will start in November 2011 and are expected to be fully implemented by the end of October 2012.

Further details on the modalities of CBPP2 will be announced after the Governing Council meeting of 3 November 2011.


Note here the frequent mention of 'full allotment', which means that no offers of eligible securities by the commercial banks in the course of these operations will be turned down. To this it should be noted that the ECB has altered the eligibility criteria for securities it is prepared to accept as collateral in refinancing operations several times, not least to keep pace with the constant stream of downgrades of euro area peripheral sovereign bonds by the major credit rating agencies. While LCH Clearnet excluded 'toxic bonds' such as Portuguese government debt from its list of eligible margin collateral, respectively increased the required haircuts in some cases significantly, the ECB decided to alter the criteria so as to be able to continue funding entities such as e.g. the Portuguese banks, which would otherwise have been left twisting in the wind. A complete list of the changes to the ECB's collateral eligibility criteria over time can be seen here. The most recent significant change has occurred on 21 September, an event we commented upon at the time – it is now clear that this has happened in preparation of the introduction of the new LTRO's.

Meanwhile the ECB has continued to provide $500 million in dollar funding to a single unnamed institution. This seems to be the same loan that has first been extended a few weeks ago and apparently keeps getting rolled over.

The important take-way from the above is that we should look forward to an expansion in the euro area's true money supply on a par with the expansion that occurred in 2008-2009. From the beginning of 2008 to the end of 2009, the euro area's true money supply increased by a stunning 21.7%. Its growth rate has floundered since then and consequently more malinvested capital has been unmasked, leading to an economic downturn. The ECB is set to reverse this trend, but we would caution in this context that the effects of these inflationary measures will only arrive with a lag. It is for instance by no means certain that the downtrend in the region's stock markets can be immediately reversed. In fact, this seems rather unlikely, but readers should take this assessment with a grain of salt: it is not possible for us to determine a priori to what extend the markets are prepared to discount the effects of the ECB's latest set of policies in advance. We will have to be content to adopt a 'wait and see' posture on that point. So far the market reaction has been positive (in the sense of 'attempting to discount more inflation'), but as a the charts of the German DAX index and the DJ EuroStoxx below show, one could easily interpret the recent rebound as a completed 'A-B-C-D-E' type correction of the preceding down wave. However, there is also a more near term bullish possibility, an alternate wave count that we also show below. To this we want to once again point out that we are merely dabblers in Elliott wave theory, so more proficient practitioners may well find fault with the counts presented here – but even if they are not entirely correct, they outline what we think are the possibilities in the near term which we think have roughly equal probability of occurring at this time. 

What favors the more bullish near term probability are the spikes in 'fear gauges' such as put-call ratios observed near the recent lows. What favors the bearish outcome is a further deterioration in the crisis, which not only concerns the euro area as it were, but also the economic deterioration in China and elsewhere. We can't know in advance what the markets will choose to focus on in the near term, but obviously there are still plenty of reasons to worry.

 


 

The most bearish wave count for Germany's DAX index we could think of. We believe  the  probability of this turning out to be correct is about equal to the probability of the more bullish (for the near term) wave count presented below – click for higher resolution.

 


 

The more near term bullish wave count, which considers that a much bigger correction of the preceding downturn may be in train. This could perhaps be compared in extent and duration to the March-May correction of wave I down in 2008. Note that the 'proposed paths' are merely idealized and not implying concrete durations or targets.

 


 

The DJ EuroStoxx Index has a roughly similar wave structure as the DAX – click for higher resolution.

 


 

More Sovereign Credit Rating Downgrades – When It Rains It Pours

Late on Friday, Fitch piled on more pressure, by further downgrading Spain and Italy. Spain was taken down two notches to AA minus, while Italy was downgraded by one notch to A plus. In its downgrade of Spain, Fitch specifically mentioned the financial troubles of Spain's regions, which are responsible for a large portion of government spending.

With this, Fitch has basically cut through the veil of creative accounting used by Spain's central government, which propped up its own budget deficit by simply cutting payments to the regions by 16%. In essence, this means that the hole in the budget has been moved from the center to the regions, but it has not gone away.

In addition to the rating action by Fitch, Moody's downgraded nine Portuguese banks, citing specifically their holdings of Portuguese government debt.  It also downgraded a number of UK banks, due to rule changes that allegedly make government support for these banks less likely in the future (in our opinion that's wishful thinking). Moody's also intimated it may soon lower Belgium's credit rating due to the Dexia collapse, which has morphed into a full-scale bailout, namely the failed bank's nationalization over the weekend. More on Dexia follows further below.

As we have mentioned previously, we think that both Portugal and Spain represent the most immediate new threat to the euro area after Greece, in spite of the fact that the markets have lately become more sanguine about Spain. Spain is one of the euro-area's economic wastelands. It is undergoing a 1930's style depression, with the recent weak cyclical recovery already giving way to contraction again. The burst housing bubble has brought the banking system to the brink, which has so far kept the true extent of the damage under wraps by means of creative accounting. Occasionally a caja or two  will blow up and admit to sudden vast losses en lieu of the previously reported meager profits, prompting the Bank of Spain's intercession. Since the government has so far been activist with regards to keeping the banking system afloat, the ultimate cost remains undetermined but is almost certainly far higher than the blue-eyed estimates that have been circulated by officialdom up until recently. What we wrote in April about Spain (scroll down to 'Spain, A Case of Crisis Fatigue – Is It Justified?') is still applicable, only the situation has since then deteriorated. While the government has met its official deficit reduction targets, the markets have repriced both Spain's debt and CDS on its debt markedly in the meantime. Lately Italy has been the market's main focus, but we think Spain's economy is far more suspect, not least due to high indebtedness of the country's households and its vast external debt.

The downturn has practically paralyzed what was one of the domestic economy's biggest sectors, the construction industry and industries related to it. The hitherto successful Spanish export sector is too small to matter, and is currently faced with falling demand as well. Construction is fairly labor-intensive and its downfall has contributed to an extremely high unemployment rate above 21%. Regional governments from the central down to the municipal level are all struggling financially, taking down the businesses that cater(ed) to them.

Spain's IBEX stock index has recently recovered smartly from its September lows (which in turn were the lowest level attained since early 2009), but as the one decade chart below suggests, a secular bear market appears well entrenched. In terms of the overall shape of the graph, the duration and extent of declines and recoveries it depicts to date, one feels reminded of Japan's Nikkei Index post 1989.

To this is must be noted that the pattern of secular declines is often very similar. Note in the long term Nikkei chart further below that the first major recovery high following the initial crash wave was never reached again and that with the exception of the 1996 high, no recovery high exceeded the one immediately preceding it. It must be noted to this that the Bank of Japan has over time become more and more reluctant to engage in monetary pumping (this has changed lately; over the past year, Japan's money supply TMS has grown by 5.1%, a high rate by Japanese standards).  Whenever the effects of an inflationary push have dissipated, the market immediately resumed its downward trend. In Japan we can also observe that secular bear markets tend to reach levels where the shares of many companies are not merely cheap, but  absurdly cheap, as the market capitalization of numerous mid and small sized companies is now clocking in below the net cash on their balance sheets.

 


 

Spain's IBEX over the past decade – following a huge bull market driven by easy money and accompanied by a vast property bubble, the stock market has embarked on a bear market that has now been in force for four years running, interrupted by a nine month long recovery. The downward sloping structure with its many lower highs is highly reminiscent of the initial post bubble downturn in Japan's stock market – click for higher resolution.

 


 

For comparison, here is a long term chart depicting the secular bear market in Japan's Nikkei index, showing the final leg up into the fateful 1989 high at nearly 39,000 points and what has happened since – click for higher resolution.

 


 

Now, we obviously don't know which path the IBEX will take over the next 15 or so years. The outcome may be less bad than in Japan. Alas, the fundamental backdrop that attends Spain's bear market is in some ways similar, and in some ways even worse than that attending the beginning stages of Japan's long bear market.

To the recent slew of downgrades it should be noted that the rating agencies have merely somewhat belatedly confirmed what the markets have already decreed. For Portugal's banks rating downgrades don't make much difference regarding their near term funding requirements, since they are already fully dependent on ECB funding. In the case of Spain's and Italy's sovereign debt it remains to be seen if the most recent ratings downgrades will make a difference. The bond markets of both countries have recently seen a bounce (Spain more so than Italy) after the ECB began to purchase their bonds, so the downgrades may undo this recovery, depending on how thoroughly the markets have discounted the event (it follows similar action by Moody's a little while ago). Downgrades are always a negative for the simple reason that some institutional investors are bound by their rules to sell debt that slips below a certain ratings threshold. Meanwhile, the threat of Belgium slipping further down the slippery credit rating slope should not be underestimated. The country is highly indebted, has only a caretaker government and is now taxed further by the failure of Dexia. Belgium has already been 'downgraded' in the CDS market and is in our opinion part of the euro area core's weak underbelly. 

 

 

Merkel and Sarkozy Meet Over Banks

 

The latest slew of downgrades undoubtedly complicates the debate over the Greek bailout and the euro area's bank recapitalization efforts, which has just temporarily culminated in yet another meeting between French president Sarkozy and Germany's chancellor Merkel. As Reuters reported ahead of the meeting, the two were somewhat divided over the proper way forward. Not only that, it is obvious that France must increasingly fear for its AAA rating – at a time when ratings downgrades are already creating a self-feeding spiral dragging down both sovereigns and banks in turn:


“Under strong U.S. and market pressure Chancellor Angela Merkel and President Nicolas Sarkozy will try to bridge differences on how to use the euro zone's financial firepower to counter a sovereign debt crisis that threatens the global economic recovery.

A ratings downgrade on both Italy and Spain by Fitch Ratings on Friday underscored the grim climate.

A German source said Paris wanted to be able to tap the euro zone's 440 billion euro rescue fund to recapitalize its own banks, which have the largest exposure to peripheral euro zone debt, while Berlin insisted the fund should be used only as a last resort when no national funds are available.

After meeting Dutch premier Mark Rutte, Merkel confirmed the German position was that the European Financial Stability Facility was a backstop to be used "only if that country is unable to cope on its own. A French Treasury source told Reuters that Paris believed banks unable to raise capital on the open market should be able to tap the fund, but talk of divergences with Berlin was premature since the issue had not yet been debated.

Merkel said struggling banks should look first to the markets, then their national government, and only in the last instance the EFSF, and with reforms as a strict condition. "This will definitely be discussed at the next summit," she said, referring to an EU leaders meeting on October 17 and 18 for which she and Sarkozy will attempt to set the agenda.

The French government and the Bank of France had dismissed until this week any need to recapitalize French banks and are now wrangling over how to do it in a way that does not put the country's top-notch credit rating at risk.

"I hear that the French are scared that too much bank recapitalization could jeopardize the French AAA and that is why they push for the EFSF solution for French banks. I expect Merkel to stick to national funds for recapitalization," said economist Jacques Delpla, a member of the French government's advisory council of economic analysis. France has the highest debt-to-GDP ratio of any of the six triple-A countries in the euro zone at 86.2 percent.

If France, the second largest guarantor of the rescue fund after Germany, were to lose its top-notch rating, the whole edifice of financial support for Greece, Portugal and Ireland would crumble.”

 

(emphasis added)

In order to get an idea of how precarious the situation for euro area banks is in spite of a spate of denials from several major banks (all of which insist that they have only a temporary liquidity/funding problem), one must once again consider the case of Dexia.

Here is a link (pdf) to the result of the last stress test of Dexia performed by the European Banking Authority (EBA) in July. As can be seen in the summary, the stress test attested that Dexia's core tier one capital ratio would amount to  a respectable 10.4% of its risk-weighted assets under the so-called 'adverse scenario'. Under the 'base scenario' the estimate was for a core tier one capital ratio of 12.1%. Ten months after the cut-off date of the year end 2010 data the stress test was based on, we find Dexia has to be nationalized because it is de facto insolvent. Since the EBA stress test identified Dexia as one of Europe's allegedly strongest banks, one has to wonder how bad things really are. No wonder the ECB is throwing around unlimited LTRO's.

Mrs. Merkel may be correct in principle, but in practice the banks can not hope to recapitalize themselves with the help of private investors. Not even Warren Buffett, who was after all prepared to stuff $5 billion into the train-wreck of Bank of America, wants to invest in euro area banks (he recently remarked in an aside that he received inquiries from some of the region's banks which he refused to consider).

We think that Mrs. Merkel and Mr. Sarkozy may have found some broad compromise, albeit one that is once again lacking in details. The press conference after the meeting was sufficiently vague on that point to indicate that their differences have not been entirely ironed out, but evidently they at least agree on the 'something must be done' formula. A summary of the rather non-committal press conference can be read at Marketwatch.

 


 

Merkel and Sarkozy at their post meeting press conference in Berlin. The slightly panicked looking chicken in the background is the eagle decorating the German coat of arms.

(Photo via Reuters)

 


 

Addendum

Reuters has constructed a nifty  'capital requirements calculator' for euro area banks that allows one to apply different haircuts to the debt of the five most vulnerable euro area sovereigns (i.e., the 'PIIGS'). We're not sure what the capital requirements calculation is based on, but presumably the EBA's last stress test was used as the basis for it. If so, then one can probably add a little to the amounts the calculator comes up with.

 


 

Euro Area Credit Market Charts

Below is our usual collection of charts of CDS spreads, bond yields,  euro basis swaps and a number of other charts. Prices in basis points, with both prices and price scales color-coded where applicable. Prices are as of Friday's close, which means they do not yet reflect the market action following the latest downgrades, as those were issued on Friday afternoon EST after European markets had already closed. We are of course curious how the markets will react to these latest developments. On Friday most CDS prices and bond yields remained near the lower end of their recent range, with a few notable exceptions such as Portugal. As mentioned above, we believe Portugal is currently the weakest link in the sovereign debt chain right after Greece. The closer Greece comes to a de facto default (the imposition of a greater private sector creditor haircut than the currently agreed one would amount to such a default), the more the markets will be inclined to speculate that Portugal is bound to  eventually share its fate.

Whether the markets will continue to focus on the vague promises of new measures regarding euro area bank recapitalization and the latest inflationary measures by ECB and BoE remains to be seen. In this case we would expect further pullbacks in CDS and a bigger retracement rally in risk assets. Alas, the markets have not yet really tipped their hand, although there are a few small positive signs such as an increase in 'safe haven yields' and a few positive divergences in the SPX daily chart (also depicted below).

 


 

5 year CDS on Portugal, Italy, Greece and Spain as of Friday. All remain within their recent elevated trading range (which looks suspiciously like a continuation formation) – click for higher resolution.

 


 

5 year CDS on France, Belgium, Ireland and Japan. All of these were still hanging on to their recent sharp pullbacks as of Friday. It remains to be seen how the nationalization of Dexia and Moody's threat with regards to Belgium's rating will redound on that situation in Monday's trading.  CDS on Japan have also retreated from their recent high, so the situation is now slightly less alarming – click for higher resolution.

 


 

5 year CDS on Bulgaria, Croatia, Hungary and Austria – note that CDS on Hungary have failed to join in the recent pullback. CEE risk generally seems to be overdue a reappraisal – click for higher resolution.

 


 

5 year CDS on Latvia, Lithuania, Slovenia and Slovakia. Nothing too reassuring yet  about the recent small dip – click for higher resolution.

 


 

5 year CDS on Romania, Poland, Slovakia and Estonia – click for higher resolution.

 


 

5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey. In this group, Bahrain and Morocco remain closest to their recent highs – click for higher resolution.

 


 

10 year government bond yields of Ireland, Greece, Portugal and Spain. Spain's yields have recently looked a great deal better, but Friday's downgrade may alter that again. Moreover, Spain faces a large amount of debt rollovers in October, so the downgrade comes at an inopportune moment – click for higher resolution.


 


 

10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note. The continued bounce in 'safe haven' yields is the only slightly positive development in sight at the moment – click for higher resolution.

 


 

Three month, one year and five year euro basis swaps – these appear to be attempting to put in a short term low in the wake of the recent bank funding related announcements by the ECB – click for higher resolution.


 


 

Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paaschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – still pulling back as of Friday and reaching a near term support level – click for higher resolution.


 


 

Inflation-adjusted yields continue their recent bounce following the inflationary policy decisions by the major central banks – click for higher resolution.

 


 

 

5 year CDS on Australia's 'Big Four' banks pull back from their recent spike high – click for higher resolution.

 


 

Lastly a look at the daily chart of the SPX. It is back above the August lows and there is a small RSI divergence and a tentative MACD buy signal. Should it overcome the declining 50 day moving average, then a bigger correction of the preceding decline will likely have begun – click for higher resolution.

 


 

 

Charts by: StockCharts.com, Bloomberg, BigCharts.com



 

 

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