The European Central Bank met today to discuss policy and economic results. At the same time, we got the results from a Spanish and Italian bond auction that many were watching as a barometer for things to come. Mario Draghi gave himself a subtle pat on the back in his statement today saying, “There are tentative signs of a stabilization in activity at low levels.” However, due to an economic outlook that “remains subject to high uncertainty and substantial risk…the provision of liquidity and the allotment modes for refinancing operations will continue to support euro area banks, and thus the financing of the real economy”. We’ve seen a lot of action by central banks in the past six months. They are obviously hard at work to stave off market weakness and uncertainty.
Central Bank Headwinds Turn To Tailwinds
Before central banks made the accommodative moves in the second half of the year, they were restricting monetary policy with the removal of quantitative easing at the Fed, raising interest rates at the ECB, and raising reserve requirements at the PBOC (China). This is no longer the case anymore. Just the opposite, we have a number of measures that are now acting as a tailwind to risk assets.
Central Bank Measures:
- ECB announced Sovereign Bond purchase program until EFSF setup
- Federal Reserve’s “Operational Twist” to lower long-term yields
- 6 Central banks reduce interest rate on dollar liquidity swap lines
- China lowers bank reserves requirement ratio
- ECB lowers rates twice
- ECB extends tender maturity to 3 years as part of LTRO
- China pushes for pension funds and insurers to invest more in the stock market
I’ve seen technical and fundamentalists swear by a magic indicator, whether it’s an exponential moving average crossover, the P/E ratio, cash flow yield, discounted cash flow valuations, leading economic indicators, the volatility index (VIX), or TRIN. Chris Puplava and I have often joked, that all you really need to do is follow the change in central bank balance sheets. Have a look at the recent changes in the ECB’s total assets.
Here, we have a 6-month lead (shifting the chart to the right six months) on the change in total ECB assets (in billions) in addition to a chart of the DJ Euro Stoxx index. By shifting the chart to the right, we’re taking out some of the lag effect to draw a more direct correlation between shifts in monetary policy and the market. The idiom, “don’t fight the Fed” seems to also ring true for the ECB.
Since November, the ECB has pared back its purchases of sovereign debt. Instead of purchasing bonds directly, the ECB is trying to again shift the buying mechanism from central bank to European banks through the 36-month tenders. It was a positive catalyst that the European banks borrowed 489 billion euros across 520 banks at a 100 basis point rate last month from the ECB; however, at that time I showed that 412 billion euros went right back into the deposit facility at a 25 basis point rate of return. I believe that like TARP, this is only a short-term issue during heightened levels of fear. Eventually, those funds will need to be invested to make a reasonable rate of return. It seems with the bond auctions of 2012, conditions are improving.
The Spanish and Italian bond auctions were trumpeted as a big success today. Spain sold 10B euros of 3-year bonds, which was double the target of 5B euros. Yields fell and the bid to cover number was also good. Italy auctioned off 12B euros worth of 1-year maturing bonds, which was the expected target, but the yields fell sharply from the last auction, down to 2.735% from 5.95% at the last auction on December 12th. Here’s a picture of the results the auctions had on the rest of the Eurozone and credit markets:
(Portuguese, Italian, Irish, Greek, Spanish, and French yields down)
Source: Bloomberg 1/12/2012
Recall last week that we had mixed results from the German and French bond auctions. The Germans sold 4.05B euros versus 5B euros they were hoping for. The bid to cover ratio improved from 1 to 1.3. The French auctioned off 7.96B euros of the intended 8B euros. Despite the mixed results, it’s a step up from December’s “failed” auction. The specter of a S&P downgrade loomed over sovereign debt at that time and still looms today, but those fears may be easing as estimates for downgrades are being priced in by the market.
The market inched a small advance today with the S&P 500 up 3 pts to 1295.50 on the strong European auctions despite the bad economic reports today. Jobless claims rose to 399k versus a consensus estimate of 375k and retail sales were light at 0.1% versus estimates for 0.4%. Strength continues to reside in risk assets with materials up 1.4%, industrials up 0.90%, and financials up 0.4% while the risk off areas (utilities and staples) and energy, on delayed Iran oil embargo and yesterday’s inventory build, fell.
The central banks in Europe, the U.S. and China have shifted from a restrictive policy to an accommodative one. They are hard at work to stem a collapse in the markets from a deleveraging event surrounding the European sovereign bonds. So far, those policies are working with the U.S. and European market up double digits from the October bottom and yields on Sovereign debt are starting to come down. Leading economic indicators are once again rising for the U.S. and Europe. Additionally, other credit risk indicators are falling such as the TED spread and LIBOR-OIS spread. Previously these were headwinds holding back the market. These economic, monetary, and credit forces look to be tailwinds, for now. Obviously, nobody knows how long the can will continue to be kicked down the road. The S&P 500 rose 35% from the 2010 summer lows to the end of quantitative easing 2.0 when our central bank went to work on deflation. The ECB’s assets are growing. CNBC talked about the next 36m Long Term Refinancing Operation (LTRO) announcement on 2/29 that could see 1T euros of demand. I’m interested to find out how much money banks are putting back into the deposit facility at the ECB. I think when that number goes down we could really see risk assets fly.
While Draghi may be toasting to signs of stabilization, this will still continue to be a minefield environment to invest in. As I mentioned last week, there are a lot of tailwinds in the 80s and 90s that are now acting as headwinds. The central banks are a tailwind until inflation rears its head and they shift towards a restrictive bias. After this year, depending on the polls, we should be prepared for fiscal policy to contract as we face our own debt demons in the U.S.
