The ECB's bold, innovative bank lending program celebrated its 3-month birthday on Wednesday. To sum up, LTRO was ECB President Mario Draghi's initiative to lend to Eurozone banks more than EUR 1 trillion in very cheap loans (about 1%) for a term of up to three years. There is no doubt that the program has had a significant impact on the European financial system, including a major reduction in European sovereign borrowing costs, not to mention the direct benefits to the banks themselves. But did the benefits of LTRO really justify a global stock market rally that racked up gains of more than $5 trillion?
Beginning with the first of two tranches last December 21, LTRO has led to a rise in the Eurostoxx 50 of 12.7%; the German DAX index of 21%; and even the Nasdaq of 21.5%. The Nasdaq, driven up by more one fifth due to a European bank funding program? If you're skeptical, have a look at the chart below (source for all charts Bloomberg):
The oval in the bottom center of the chart shows the day on which LTRO was initiated. As this chart makes clear, the effects of easy money are global, and universal. Compare the above chart with the chart of the German DAX stock index (below), and how it reacted to the initiation of the US Fed's QEII during the summer of 2010, beginning with the August 27 Fed Chair Bernanke kick-off speech:
In all respects, LTRO is very similar to QE, at least regarding the effect on equity and other markets. There is one important difference, however. With QE, the Federal Reserve buys treasury bonds on the open market, and the cash from the Fed purchases makes its way into the financial system. With LTRO, the only concerned parties are Eurozone banks. The banks pledge collateral to the ECB, and receive loans for up to three years. However if the banks do not put the loan proceeds to work by lending to their customers or investing the proceeds, there is no real impact from LTRO. The only benefit is helping banks to manage their liquidity needs.
The chart above shows ECB overnight deposit balances from banking institutions over the past 6 months. By monitoring these deposit balances, we can see how much of the LTRO proceeds is making its way into the economy, to be used to buy stocks, lend to sovereigns, etc, or how much is staying at the ECB. As we can clearly see from the upward move in deposits as shown above in ovals, overnight deposits at the ECB rose dramatically following the two LTRO operations.
Although the total amount of LTRO loans exceeded EUR 1 trillion, the net amount of new loans amounted to almost exactly half of that amount, at EUR 504 billion. The balance consisted of existing loans by the ECB that were rolled over. The first LTRO tranche comprised EUR 193 billion in new loans while the second LTRO tranche was made up of about EUR 311 billion in new loans.
From the chart we see that ECB overnight deposits rose by about EUR 200 billion following LTRO I, and by about EUR 300 billion following LTRO II. This, as we know, is nearly exactly the amount of net LTRO loans extended by the ECB to the banks. In other words, every new euro of new loan that the ECB made, came right back to it in the form of overnight bank deposits. ECB President Draghi defends this outcome by claiming that different banks who borrowed did the lending. But from a systemic point of view, that claim doesn't make any difference. The details of interbank lending do not change the overall net loan amount by the ECB, which is effectively zero.
How then could stock markets rise by as much as 20% if no money actually entered the system? As with QEII, markets apparently rose in anticipation of the injection of more liquidity into the system. Following Bernanke's Jackson Hole speech in August 2010, markets rose in dramatic fashion in the three months preceeding the actual beginning of QEII, with the S&P 500 adding nearly 18% before even one dollar changed hands.
As with many things, perceptions matter. Since the initiation of LTRO, confidence has returned, and economic activity has exceeded expectations. As part of our ongoing market research we quantify the extent to which economic data exceeds, matches, or falls short of expectations. Since December, European data has generally exceeded expectations, meaning that real business activity seems to have picked up as a result of LTRO. Businesses have concluded that the banking system is on the mend, and that production can be expanded.
But there is a point where perception ends, and reality takes over. This point was driven home by Tuesday's release of Dutch consumer confidence:
Consumer confidence in the Netherlands has now exceeded the lows set during the height of the financial crisis back in the spring of 2009. As far as the Eurozone is concerned, Main Street does not seem to be sharing the same sense of confidence as the European business community.
But businesses may be beginning to realize that their LTRO assumptions were overly optimistic. Yesterday we saw the release of Germany's manufacturing Purchasing Manager's Index:
This particular graph shows not only the actual data (in blue), but also the consensus of surveyed economists (in red). Note that over the past six years, the actual number and expectations have been nearly identical--until yesterday. Here we see that although economists were expecting a rise from last month's reading of 50.2 to 51, the actual number was 48.1. Since readings below 50 indicate contraction, the 48.1 release was clearly in recession territory. This number not only indicated economic contraction, it also surprised economists by the largest amount since Bloomberg began maintaining the pair of series.
Dutch consumer and German business outlooks are not the only LTRO-affected indicators to waver. Although some sovereigns such as Italy have benefitted from LTRO in terms of borrowing costs, with Italian CDS premiums falling to 3.75% from about 5% at the time of the first LTRO tranche, other countries such as Spain are no better off. Spain's CDS premium has actually risen since the first LTRO tranche, from 3.98% to 4.33%. Other countries such as the Netherlands have shown a net improvement, falling from 1.22% to 1.07%, but well off the lows of 0.92% hit earlier this week. Holland's net gain is modest indeed.
There is no doubt that LTRO has had a very large impact on the European financial system, and by all appearances seems to be a very effective and efficient measure in restoring its functionality. However, we must keep in mind that LTRO did not address bank solvency issues, only bank liquidity. The quality of bank balance sheets did not change overnight. Similarly, very little of the EUR 500 billion in loans has actually entered the system. As such, it is hard to justify a 20% global equity rally on the premise that it was liquidity-driven. As we saw following QEI and QEII, we may well be headed for a correction now that LTRO has had time to run its course.