What would have been the decline of European equities if the 3 year long term refinancing operation (LTRO) of the ECB would have seen a lukewarm response of banks? I suppose significant considering that the enthusiastic response seen yesterday (EUR 489 billion taken up by 523 banks) only had a very short-lived positive impact on equity markets. Does this mean that the entire operation has been pointless from a market perspective? Not at all. Importantly, investors will have a more relaxed feeling about the considerable refinancing of bank paper that is due to take place next year. If investors would not reinvest all of the maturing paper, the banking sector liquidity needs would be met by the refinancing operation in December 2011 and a similar operation in February 2012.
Admittedly, the LTRO does not address directly the financing of budget deficits of eurozone members although indirectly there is a link when banks use the liquidity provided to buy government paper which is then used as collateral for loans from the ECB. For that reason, a country like Spain had seen quite a decline in its 3 year bond yield after the announcement earlier this month that the 3 year LTRO would be organised. The key question is of course to what extent liquidity will indeed be used to buy government paper. We’ll have to wait and see. One should expect this will be function of the progress made in other areas and in particular on the new governance model agreed upon at the latest EU summit. The upcoming political summits will (again) be crucial.
Against the background of the negative comments in many analyses and articles on the absence of a bazooka (a highly leveraged EFSF, ECB as buyer of last resort), on the outcome of the most recent EU summit as well as on the LTRO (I’m referring to the negative equity market reaction), there is a risk of losing sight that gradually progress has been made:
- The ECB has eased it policy (cut in the official interest rate; two 3 year LTROs; facilitating funding via covered bonds; reducing the reserve ratio from 2% to 1%; etc) which will give a considerable boost to liquidity (the reduction in the reserve ratio frees up EUR 100bn)
- The firepower of the IMF is being increased
- Governments have committed to a fiscal policy which will bring the structural deficit back to maximum 0,5% of nominal GDP. Automatic correction mechanisms are foreseen as well
- The entry into force of the European Stability Mechanism has been accelerated and an emergency procedure for decision making has been introduced
- The ECB has accepted to act as the agent of the EFSF which indicated the latter is getting ‘ready for action’
Clearly, there are still many uncertainties, notably on translating the new governance framework into legislation, and investors understandably adopt an attitude of ‘better be late than sorry’. Risk aversion comes with a price though, it is sufficient to compare the level of short term rates to inflation. The liquidity which has been put in the system via the first 3 year LTRO and the reserve ratio reduction and which will be complemented by the second 3 year LTRO (which probably will again be successful), in combination with an overweight of low yielding low risk assets and safe havens create a huge pent-up demand for risky assets. The big question is when this will be unleashed. 2012 is about spotting this catalyst.
William De Vijlder
Chief Investment Officer, Strategy & Partners, BNP Paribas Investment Partners
22 December 2011
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