Interpreting the Activity of Banks and the ECB Correctly
It appears that market observers are only very slowly coming around to grasping the fact that what the ECB has done in December does indeed amount to a major dose of monetary pumping. The misunderstandings center mainly on the use of the ECB's deposit facility by banks, which overshadows the far more legitimate debate over whether the commercial banks are going to use ECB funding to play the sovereign debt carry trade or rather 'play it safe' in view of the large amount of bank bonds maturing in the first quarter.
Now, to the latter point let us say this: there is now some evidence that they indeed do play the carry trade, by 'riding the yield curve' in e.g. Italian bonds. The proof is in the pudding: the Italian yield curve has gone from a slight inversion to quite a bit of steepness. The recent move has in fact been enormous. Italy's 2 year note yield has plunged from about 7.60% in late November – at which point the spread between the 10 and 2 year note yields was inverted by nearly 60 basis points – to 4.67% today. That's a move of approximately 300 basis points in a mere six weeks. As we have remarked previously: someone has been buying, and it sure wasn't Santa Claus.
Italy's 2 year note yield has plunged by 300 basis points since late November – click chart for better resolution.
Slowly but surely a few mainstream publications are catching on to the phenomenon as well. The Wall Street Journal for instance noted yesterday (finally): 'Evidence the ECB Could Be Running Backdoor QE After All'.
Well, duh. Pumping nearly €500 billion into the banking system in a single day means the money is going to go somewhere. Since the private sector's credit demand in euro-land is negligible and riding the curve promises to be highly lucrative, it isn't too difficult to guess where it will go – especially in view of the fact that governments and banks are becoming ever more intertwined via debt guarantees and capital raisings, even in nominally bankrupt Greece (as we reported yesterday).
It should be obvious that governments won't just support their banks without getting a little something in return.
The WSJ article notes:
"Earlier, we questioned Bill Gross’s assertion that the ECB was offering backdoor QE to euro-zone sovereigns with its Long Term Refinancing Operation.
Most analysts figured the LTRO would be used mainly to help banks cover their own borrowing needs, rather than supplying a pipeline of free cash to the sovereigns.
And sure enough, long-term sovereign borrowing costs have displayed little impact of the LTRO, with Italy still paying nearly 7% to borrow for 10 years. But now it looks like there’s evidence that Bill Gross might be on to something, that maybe the LTRO could in fact be helping European sovereigns borrow, but for the very short term rather than the long term.
We were alerted to this by Friend of MarketBeat (FOMB) Tom Lauricella, who sent along a note from Soc Gen currency strategists saying European banks have been using their LTRO cash from the ECB to ply a carry trade at the very short end of the yield curve:
Look at the front end of sovereign curves as a guide, rather than the back end. While FX markets are fixated by the back end of European sovereign curves as a sign of fiscal sustainability, fixed income investors continue to run a carry trade investing in the front end of the curves. For example, 3 and 6M Italian BTP yields have been dropping sharply even as the back end of the curve is a bit better bid. There is precious little credit and market risk in the front end of the curve but high yield. Banks can borrow at the ECB and pick up this premium.
The ECB seems to be succeeding in restoring the plumbing of monetary policy. Investors are now scrambling to join the bandwagon which should prove risk supportive. This form of indirect credit/quantitative easing also suggests that EUR will have a tendency to drop and particularly relative to SEK, NOK and GBP.
According to Tradeweb data, since the LTRO on December 21, the yield on Italy’s six-month bill maturing on Feb. 29 has fallen from 2.7% to 1.7% — that’s a fairly sizeable drop, and every little bit helps when you’re a borrower. And it’s far, far better than the peak closing yield north of 7% in early November. One way or another, and probably with the help of the LTRO, or at least banks’ anticipation of it, Italy has gone from pretty much a crisis state to a merely painful state.
As Bridgewater’s Bob Prince told Tom in his must-read profile, this is not exactly a sustainable situation: “You’ve got insolvent banks supporting insolvent sovereigns and insolvent sovereigns supporting insolvent banks,” he says.“
(emphasis added)
Regarding this last statement, one should perhaps not forget that Italy's government (contrary to Greece's) has historically never welched on its debt. Moreover, if one considers the financial situation of Italy in its totality (incl. e.g. unfunded liabilities), one must conclude that in spite of the eye-catching official 120% public debt-to-GDP ratio, Italy looks in many respects financially more sound than e.g. Germany. This unexpected conclusion was provided a while back by Albert Edwards of SocGen, and he is normally not exactly someone inclined to display a particularly sunny disposition or apt to ignore bearish fundamental evidence, so we can probably take his word for it.
Insolvency: The Natural State of the System
Lastly, both the banks and the sovereigns have always been insolvent, and always will be. A fractionally reserved banking system is insolvent by its very nature. Consider that e.g. only 4.6% of all the money substitutes extant in the euro area were actually backed by standard money at the end of November 2011. Theoretically, if the banks were asked to pay out more than 4.6% of all demand deposit claims, they would have had to declare a 'bank holiday'. In practice the central bank would of course help out, but the fact remains that a banking system that promises its depositors that they can withdraw almost € 4 trillion at any time they want, and in reality holds only € 200 billion in reserve to satisfy these claims is de facto insolvent.
The same goes for governments: no-one in his right mind expects their perpetually rolling over debts to be ever paid off. And if they should be paid off, then certainly not with money the purchasing power of which even remotely resembles that it possessed when the debts were originally incurred. Paul Krugman may think that the current yield on the 10 year treasury note below 2% is an open invitation to increase the public debt further into the blue yonder, but the reality of the situation is that market participants will only retain their faith as long as they can be induced to believe that there won't be a problem with rolling the debt over. In other words, they will come and play only if they believe that other market participants also believe that it will be possible to continue to roll the debt over.
There should not even be a debate over the fact that for all intents and purposes, the system as a whole is not solvent. Nothing new has suddenly been discovered in Europe. All that has changed are the perceptions of market participants, but not the facts as such. That insolvent banks are supporting insolvent sovereigns and vice-versa was already the proper characterization of the situation before the crisis, and will remain the proper characterization of the situation in the event that the crisis should pass. Insolvency is the natural state of the system.
