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Friday December 16, 2011 - 20:21:49 GMT
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ECB in Unholy Alliance with EZ Banks - lower EZ periphery bond yields next week

ECB in Unholy Alliance with EZ Banks - lower EZ periphery bond yields next week.


Since last Thursday’s ECB Governing Council meeting and President Draghi’s press conference, it should be abundantly clear that the ECB will not buy EZ (distressed) debt in an unsterilized fashion and in fact the sooner the EFSF is up and running as a buyer of EZ debt, the sooner the ECB will abandon its current fully sterilized bond purchase program SMP.


Does this mean the ECB is throwing the sovereigns to the wolves of the marketplace? Hardly.


The ECB with the help of the EZ banks will float both bank and sovereign financing needs without ever buying sovereign paper as LOLR to a government. Instead the ECB in an unholy alliance with the EZ banks will lend banks unlimited funds at a rate not much above the refinance rate now at 1% for up to 3 years and without any stigma attached to a bank in distress. This is conscription borrowing. All (banks) must “volunteer” to borrow huge amounts of euros from the ECB and instead of holding them on reserve at the ECB as has largely been the case banks will “volunteer” to buy EZ debt.


You may be asking yourself what bank will buy EZ debt willy nilly when the euro’s very existence has been challenged and is at risk? Banks which are all but ordered to buy that is who. But there is also evidence that the banks are not going to face what they do now on Greek debt – haircuts on sovereign debt ahead. We have read and heard lots about what the EU Summit agreed to in its new compact on fiscal convergence. But little focus was put on the decision to drop PSI (private sector involvement or bank and insurance companies agreeing to haircuts from distressed sovereigns like Greece in some intermediate stage before default – creditor purgatory). And who insisted on dropping PSI (Greek roadmap) from the Summit compact? The ECB. The ECB wants sovereign debt to remain “risk free” and if PSI was incorporated into the EU’s compact (near constitution) it would surely end treating EZ sovereign debt as risk free and hence require some risk weighting no at 0%...tying up capital and crippling the banks.


So where should we look for evidence of the “fix” is in? The size of the LTRO’s ahead, particularly the 3-year LTRO which is set for next Tuesday (bids) with the allotments announced Wednesday. We should also look for evidence of the “fix” in bank balances held at the ECB (excess reserves). These have grown large through the crisis and are running at highest levels since early 2009. If banks are taking funds from the ECB and buying EZ debt (earning attractive carry on periphery debt, but also Bunds…assuming banks have loaded up on the latter already) we should see this in a leveling off of excess reserves held at the ECB or even a decline if the practice is being embraced by the banks.


If banks have now a guarantee that EZ 16 (ex Greece) will not have a haircut or PSI event a hard default risk is not going to force a change in how banks account for risk weighting on sovereign debt – it won’t tie up bank capital…it will be no different from an accounting perspective than taking euros from the ECB in an LTRO and depositing them at the ECB.


So the ECB floats bank financing and sovereign financing in one giant turkey stuffing exercise. The ECB sees the LTRO’s as temporary, not a permanent increase in the money stock, and hence not monetization, not QE. Yes the loans will bloat the ECB’s balance sheet much as direct bond purchases would, but it is done as a credit/liquidity operation and not a LOLR operation to a EZ government in distress. There is some evidence that in the most distressed bond markets in the Euro Zone, national central banks and governments have pressed their banks into bond purchases. But if I am right about what will happen next week, we could see a whole new level of EZ bank debt support that could move yields down much more dramatically.


Is all better? Hardly. No amount of cologne can hid the order from the encroaching recession. Between debt overhang in the public sector (in private sector in Ireland and Spain where there were property bubbles) and nothing from the policy front to support growth (ECB admitted that interest rate cuts are not working – Draghi Thursday). Quite horribly, the geniuses in Brussels, Frankfurt and Paris have decided that austerity is now needed to restore growth. And one key axiom holds…liquidity is not a pathway to solvency. Solvency risk will rise even if the ECB succeeds initially at squeezing EZ shorts from periphery debt markets (and longs from bunds as spreads come in). Watch Ireland – once the poster child of economic growth (Celtic Tiger), now the poster child of austerity and sacrifice. Ireland will soon be the poster child of bailouts…Q3 GDP fell 1.9% q/q, the worst in the EZ after Greece (Greece stopped publishing seasonally adjusted GDP – RTRS) and from second best in Q2. And this is happening with the recession everywhere else in the EZ just starting (some have noted skewed manufacturing sector is in pharmaceuticals and as patents roll off on some of the blockbuster drugs made in Ireland, its exports could collapse in the next 2 years).


What does this mean for markets? I would think we get a rally in risk next week on LTRO and bond buying expectations. But unbathed, unshowered the euro odor can’t hide indefinitely behind ECB cologne.


David Gilmore




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