European bankers, beleaguered by a myriad of problems, mostly related to the sovereign debt crisis, received a holiday bonus today. The ECB generously offered banks and loans at the current bank rate of 1%, for a three year period. The ECB reported 523 banks requested €489B, making what the ECB calls a longer-term refinancing operation a resounding success.
A prerequisite for the bank's 1% loans was appropriate collateral. The ECB had reduced the qualification terms. The relaxed requirement allowed banks to shed their portfolio low quality loans as well as loans that were difficult to determine the current market value.
For the under capitalized European banks, this liquidity injection was a divine act. Banks will be in a position to replenish their capital, make new loans to the private sector, or buy more sovereign debt. It is their choice. The outcome is unclear. Will it give the economy a boost or will it merely keep the ailing banks solvent?
The initial reaction in the currency markets was clear. As the hourly chart of the EUR/USD illustrates, the pair rallied to 1.3197, and, after the announcement, tumbled to 1.3026. Confronted with a new supply of almost half a trillion euros, the market judged this to be bearish, analogous to the quantitative easing in the U.S. and Britain.
Financial ministers on both sides of the Atlantic have been urging the ECB to use monetary actions to stimulate the economy. An article in the Telegraph today suggests we may have underestimated the actions of the ECB. A European think tank, Open Europe ...
... reckons there’s a big financial hurdle too: The ECB has already intervened massively - through its bond buying program and support for banks - and is now dangerously exposed to the sinner states already.
The think-tank’s report says: “Through its government bond buying and liquidity provision to banks, the ECB’s exposure to the PIIGS has now reached €705bn, up from €444bn in early summer. This is an increase of over 50pc in only six months and shows how, contrary to popular belief, the ECB is already intervening quite heavily in the markets.”
The problem is with the banks as well as the sinner states. The ECB has made supporting Europe’s beleaguered banks one of its core policies. It had opened its doors and lowered its collateral requirements.
In practice, banks are able to both borrow and dump low quality collateral in one go. Open Europe says “though not all of these assets are bad or ‘toxic," they are extremely difficult to value.”
So the injection of liquidity, helpful now, comes with a deferred risk. A future write down in the value of sovereign debt may result in a capital call upon members by the ECB, but for now, it appears the can has again been kicked down the road.
This comes at a time when the euro is loaded with spec shorts. Last week's COT report revealed that speculators were short a record 144,835 contracts of futures and delta adjusted options. Such a large short position coming in the holiday season when trading ranks are often deleted seems risky. There is also end of the year accounting issues, which, in a thin market can make for some unpredictable trades.
The longer trend in the euro remains lower but during the holiday season thin markets may present opportunities. We suspect there will be profit taking by shorts in the 1.30 area. Should today's wave of bearishness pass, it is possible a short squeeze could emerge. A rally back to the 1.3250/1.33 is a possibility, and a level we would consider re-entering on the short side.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.