What a difference a month can make in the world of global financial markets! The wave of pessimism that swamped investors during the last few months of 2011 appears to have subsided. Most risky asset markets are enjoying one of their best starts to the year in over a decade. That said, market participants across the globe are feeling a touch nervous about whether this spell can continue indefinitely given the concerns about fiscal consolidation dampening growth in 2012. Before we try to answer that, it would be important to understand the main factors behind the recent rally.
The key factor driving the “risk-on” trade at this point in time is really the result of the major economies – the US, China and the euro zone – moving into a so-called “sweet spot”. The sweet spot is a situation in which inflation is falling, growth is rebounding or showing signs of stabilisation and monetary policy is expansionary subsequently creating an ideal investment environment for higher yielding assets.
The real game-changer for the markets was the European Central Bank’s (ECB) three-year long term refinancing operation (LTRO) that was aimed primarily at ring-fencing the banking sector. Back in 2011, global investors had two sets of concerns about the European sovereign crisis. The first was the ability of fiscally-stressed states such as Italy and Spain (whose sovereign financing needs are heavily front loaded in 2012) to meet funding requirements in stressed market conditions. The exposure that European banks had to peripheral debt and the possibility of a bust if a sovereign defaulted was another concern for the markets. The LTRO – that involves euro-zone banks bidding for unlimited amount of liquidity by pledging collateral to the ECB – is turning out to be the right short-term solution in protecting banks from the prospect of a default-led liquidity freeze as well as in propping up sovereign debt markets
In the three-year LTRO that was conducted in December, European banks bid a cumulative amount of around euro 500 billion. The improvements seen after the LTRO are fairly visible. By providing direct liquidity to the banking sector, it has taken bank funding risks off the table for the market, ensured that bank deleveraging is more orderly and diminished the tail risk of a systemic banking sector crisis. The LTRO has also encouraged an internal carry trade within the region wherein banks borrow at low interest rates from the ECB around the one per cent mark and purchase higher yielding sovereign bonds that yield anywhere between three per cent and six per cent. This has, in turn, started pushing down sovereign bond yields and restored confidence in the ability of some of the stressed states (Italy and Spain) to fund their deficits subsequently. Consequently, another large take-up by European banks in the LTRO that is scheduled on February 29, 2012 could provide further impetus to the current risk rally.
Will the LTRO programme result in increased global liquidity that could drive risky assets higher for a sustained period of time? Not quite. Indeed, the LTRO is a sort of quasi-QE programme wherein the ECB is providing liquidity to the banking sector via collateralised lending. Thus, it comes down to how the banking sector uses the liquidity that will determine whether it seeps into the broader financial markets.
Early indications are that most European banks that are availing of the facility are either using it to purchase government bonds or parking the excess liquidity back with ECB in its deposit facility. Unfortunately, European banks still have significant capital constraints and investing in sovereign debt requires less capital than channelling it through to hedge funds and other financial entities. Furthermore, the deleveraging process is far from over and European banks are likely to exhibit risk aversion that will stop them from entering into funding risky assets. The net result is that the liquidity being provided by the LTRO is unlikely to find its way into commodity markets and the broader financial sector in the way it happened during the US Fed’s QE programme in 2010-11. All that the LTRO has done is to improve funding costs and changed the perception of the severity of the European sovereign crisis bringing about some relief to the markets.
A lot more needs to be done before one can conclude that the crisis has been resolved. The LTROs will do little to resolve long-term issues such as ensuring adequate demand for sovereign bonds over the course of the year, ability of fiscally-stressed states to meet deficit targets on the back of the weak growth backdrop and the possibility of Portugal requiring additional aid. The other dampener could set in once economic indicators begin to flatten out as fiscal consolidation sets in weakening growth in the advanced economies that could crush investor optimism. The upshot is that the “sweet spot” trade could be replaced by the “reality check” trade that could mean another round of risk aversion. Eventually, the ECB will have to do more possibly by embarking on a direct QE programme in which it significantly increases its purchases of sovereign debt to fight a recession and provide further leeway to the struggling peripheral region.
The authors are with HDFC Bank. These views are personal
