Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week
1. ECB’s Long Term Refinancing Operations (LTRO)
This was the big event of the week.
On Wednesday the ECB initiated the first of two 3-year LTRO’s (long-term refinancing operations), allowing EU banks to borrow unlimited amounts for 3 years at 1%. The big innovation was that collateral standards were reduced to include GIIPS debt. In other words, they could borrow unlimited funds at 1% using very questionable collateral and then lend out those funds at a higher rate. The ECB lent €489 billion ($640 billion) to 523 banks.
Significance: Boosts Banks, Not GIIPS
This was by far the biggest event of the week.
What It Accomplished: ECB QE Begins, Bought More Time As Bank Liquidity Improved, Banking Crisis Deferred
It once again deferred the danger of a near term banking crisis by insuring that the big EU banks had access to needed funds to continue operations.
It allowed the banks to dump low quality GIIPS bonds to a taxpayer funded entity, the ECB, and in return get cheap cash that can be deployed at higher rates, allowing the banks to profit on the difference and build up their cash reserves to better withstand the banking crisis that will follow when Greece defaults. If that leads to other GIIPS defaults, the banks’ exposure has been reduced because much of those bonds are now in ECB hands.
It officially answered the question of whether the ECB would ever adopt Fed-style QE. It has. The LTOR expanded the ECB balance sheet by 20%, and this comes on top of the dramatic expansion of its loans in recent months, as shown in the chart below.
(via seekinalpha.com) 01 dec 24 2302
We don’t believe the banks will touch these bonds under current conditions without extreme official pressure. More on that below.
What It Didn’t Do: Make Any Meaningful Progress Towards Solving The Solvency Problem
- Solve the fundamental problem that’s scaring markets improve actual solvency of the banks and the GIIPS themselves. The LTOR should have no meaningful long term impact on GIIPS bond yields and borrowing costs. This was obvious to everyone, including the ECB.
- Provide any realistic hope that the banks would use the funds to buy more GIIPS bonds and lower GIIPS borrowing costs. Yields on short term Italian bonds indeed fell towards the end of the week. As of Friday, however, yields on benchmark 10 year Italian bonds remained near the unsustainable 7% level. Exposure to toxic GIIPS bonds is the biggest concern banks face from their lenders, investors and directors. They’re in the process of reducing that exposure, not increasing it. Adding bank liquidity does nothing to change this picture
The best article of the week to capture this sentiment came from zerohedge.com, see here for details.
Conclusion: LTOR Is To Prep Banks For GIIPS Defaults
Given that the above is clear to the ECB and EU leaders, the LTOR reinforces our belief that their goal now is to buy time to strengthen the banking sector as much as possible to withstand the pressure when the sovereign and bank defaults start to role in once Greece defaults. As Fitch declared last week, the EU sovereign debt and banking crisis is now beyond solution, and the LTOR suggests that the EU leadership now agrees, regardless of what they say. It’s now trying to salvage as much of the banking sector as possible.
Reflecting the fundamentally unchanged situation in the EU, the EURUSD barely moved up this week despite the ECB’s dramatic action.
2. Monday Markets Lower On The Following Short Term Market Movers
EU Contribution To IMF Rescue Efforts Below Expectations
Total contributions were about €150 bln versus a hoped for €200 bln. The news helped pressure risk asset markets Monday. This failure fits with our reading above that the EU leadership has given up on a solution and is finding only limited enthusiasm for tossing additional taxpayer money at the GIIPS.
Fed Agreement to Basel Capital requirements
The additional capital requirements are expected to pressure US bank profits going forward.
Death of Korean Dictator
This news briefly pressured Asian markets on uncertainty about whether the power transition would be peaceful. So far, so good.
3. Tuesday Markets Rebound On Better Than Expected Data, LTOR Anticipation
Markets got some support from better than expected German Ifo sentiment, US housing data and Spanish bond sales. As usual, there are many claiming the US housing results were overstated because they ignore the massive shadow inventory. However we suspect that the Tuesday’s rally was as much due to hopes from the coming LTOR (announced Wednesday).
Noteworthy But Not Market Moving
- Iran begins a 10 day naval exercise in the Persian Gulf aimed at demonstrating its capabilities of shutting off the straits of Hormuz, where 20% to 40% of the world’s oil must pass.
- There were more reports on the collapse of Chinese real estate prices from 30% to 50% off their highs. This is significant because land sales are key source of revenue for indebted municipalities. If the China hard landing story gains traction that would place further downward pressure on global markets as China has thus far been the sole big growth story of recent years as the developed world economies continue to struggle.
LESSONS & RAMIFICATIONS
So what do we learn from the above?
Conclusion: Last Week’s Rally Fueled By Short Term Relief, Technical Bounce, Low Volume
Despite a downward revision of US GDP to 1.8%, markets were able to rally through the end of the week. The rally was ultimately based on:
- Relief That Both The EU And US Had Again Deferred Debt Related Pain: The LTOR should buy some time for the banks, and the US managed a two-month extension of its payroll tax cut.
- Low volume: as the big traders go on vacation and leave underlings in charge to keep watch.
- Room Before Hitting Significant Resistance: For example, the next major resistance on the S&P 500 was at around 1270, where there’s dual resistance from both October highs and the 618% Fibonacci retracement of the downtrend from the year’s high around 1360, as shown (labeled A) in the S&P weekly chart below.
S&P 500 Weekly Chart 02 dec 25 0015
With thinning holiday volume and some room before the S&P 500 hits technical multi-month resistance around 1270, these were enough for a modest rally.
Ramifications Of The Past Week’s Events
The main ramifications include:
A Bad Week For the EUR’s Prospects: ECB QE: Good For Stocks, Gold, Bad For EUR
- ECB QE: Although added bank liquidity is only inflationary if banks actually lend out the money (far from clear as banks seek to build cash reserves) QE is typically seen as potentially inflationary and so markets could further sell off the EUR, already under pressure from both the overall uncertainty of the debt crisis and the ECB’s easing stance.
- EU Giving Up EZ As We Know It? Given the past week’s events:
- EU failure to raise the full €200 bln for IMF aid to GIIPS
- ECB’s LTOR as a move to save what it can of EU banking
It’s possible that over the coming weeks markets will believe the end of the EUR as we know is coming, and that would put further downward pressure on the currency
Beneficiaries Of These Events: Stocks, Gold
QE is usually good for stock markets because banks tend to deploy some of their QE cash there. If fear of an imminent EU crisis and likely deflation ease, the inflationary potential of the ECB’s QE could spur demand for gold from those holding Euros.
Barring any shocking news, we expect more quiet range bound trade due to:
- Low volume from bank holidays in much of the West Monday and Tuesday
- A light economic calendar
Nonetheless, there are events next week that have the potential to stir volatility. See Part 2 for details.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.