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On the ECB’s Long-Term Refinancing Operation and 2012 Macro Ideas for Investors

The end of year is usually a good time for markets. There was a lot of angst about the European situation a few weeks ago, but there is less of that now because we’re hitting year-end (tape painting). Does that mean the credit crisis situation is stable? No, but it has stabilised somewhat. 2012 will be a different story though. I talked about the European sovereign debt crisis and my themes for 2012 with Howard Green of BNN and Ryan Avent of the Economist yesterday. The link to the video is below but let me say a bit more, particularly about today’s LTRO by the ECB. I’ll try to be brief.

With the LTRO, I see the ECB fulfilling my predictions from last month. See “Why questioning Italy’s solvency leads inevitably to monetisation” and “Why Investors will buy Italian bonds after ECB monetisation“.

The background is what I outlined in 2009. Here’s how I would put it in context today:

  1. Global growth is weak and policy space is more limited after an epic credit crisis.
  2. To maintain demand, with household sector debts and unemployment high, sovereigns have turned to deficit spending. However, this high level of deficit spending is either politically unacceptable or market unsustainable depending on the institutional currency arrangements.
  3. Therefore, at the first sign of economic strength, the US and the UK will cut spending and try to reduce deficits. Euro area governments will be forced to by markets as well. The result will be a deep recession with higher unemployment and lower stock prices.
  4. Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with.
  5. Liquidity provisioning will create a false boom, predicated on asset price increases until the prop of government spending is taken away. When the prop of government spending is taken away, the global economy will relapse into recession. If China takes away their own prop, the global economy will immediately relapse into Depression with a capital ‘D’.

So what the ECB has done with the LTRO is relevant to points 4 and 5. They are providing liquidity to banks that must use government IOUs as collateral for that liquidity. Essentially, the ECB is winking to banks that it will provide them liquidity out to three years for lesser collateral (read: Italian bonds) as long as the fiscal austerity union is still in play. That means that the ECB’s providing bank liquidity is really a back door way of allowing the Italians to roll over their debt at less painful rates. This is otherwise known as monetisation. You give me euro area government collateral and I give you free money for the next three years. That’s what LTRO means.

With the ECB going to liquidity arrangements for three-year money, it tells you this is back door rate easing. Now the ECB hasn’t come out and said it is going to a permanent zero type of stance like the Fed. But you have to believe that fiscal austerity combined with their recent cut foretells a future of low rates and effectively guarantees low rates on Bunds (and Dutch bonds) out to three years. Other countries will only get this guarantee via ECB liquidity and the resultant spread to Bunds.

Remember, euro zone banks are still in deleveraging/capital raising mode. It’s not like they now have extra peripheral bond money to play with. Perry Mehrling gets this one right with his comments on how the ECB’s taking on the market intermediation role reduces liquidity via reduced bond rehypothecation. Check out Bloomberg’s “Bonds Stop Flowing as Collateral Gets Stuck at ECB: Euro Credit” (hat tip Scott). Here’s the money quote:

“The system is collapsing onto the balance sheet of the most-solid member of the system, which is the central bank,” said Perry Mehrling, professor of economics at Barnard College, Colombia University in New York. “The central bank is on one side of the market only. The bonds are flowing in and they’re not flowing out again.”

Nevertheless, just as I believe the Fed has already begun its third easing campaign via its more explicit cap in August, I think the LTRO is really the ECB equivalent of QE3.

Clearly, there are more elegant ways to achieve their ends but the reality for the ECB is that an Italian default means Depression and so the ECB has concocted this scheme to keep the liquidity taps for banks open while the fiscal union idea plays out, hoping that it can avoid taking more aggressive measures.

Financial Armageddon is still on the table via a euro bank run or an Italian default but I am more convinced now than I was in November that the ECB will blink when the game of chicken reaches the critical state. That gives domestic banks a green light to get on the sovereign debt rollover train and Bloomberg News reports that Italian banks are doing just that.

In sum, Europe is certainly a problem that will flare because the longer-term solution is a combination of credit writedowns, more bank capital, a lender of last resort and economic growth. Right now, the solution is no credit writedowns, maybe some bank capital eventually, some monetisation and economic anti-growth. Big difference.

So I expect Europe to continue the extend and pretend approach, creating volatility and crisis. And the question again and again will be: does the ECB write the check. I believe they will.

My macro concerns are elsewhere. The problem resolution in the US and Europe are known unknowns. But now there are new known unknowns on the horizon: the slowdown in the BRICs, the resulting impact on commodities and the housing bubbles in Australia and Canada, and the wider fallout for the global economy. These situations lead inexorably to the unknown unknowns that create volatility. i believe all of the risk in those situations is to the downside.

Here are some macro ideas:

  1. Europe is cheap, as Niels Jensen says, . Value Walk has pointed out a good chart from Barclays on that score as well. If the ECB continues at least a partial backstop, euro shares could outperform and lower beta, higher dividend plays would be a good toe-dip. If they don’t, all shares go down globally, North America as much if not more than Europe.
  2. Euro banks and euro peripheral sovereign are still toxic. We have no clue how the euro crisis flares. there are 17 euro area members and 10 EU members outside the zone. Britain’s veto of the fiscal pact pushed by France and Germany tells you there are a lot single points of failure in this complex system. The euro zone is not a redundant system, engineering wise then and i would avoid the weakest links there: periphery debt and euro banks.
  3. The BRICs slow, making outperformance there unlikely. Brazil, India, China and Russia are all coming off the boil. The interest rate cycle is clearly down there as well. To my mind this speaks to flattening yield curves and risk-off and means that the days of heady outperformance in EM are over. Yes, there are some plays (like Indonesia or Mexico at the sovereign level perhaps) but from an asset allocation perspective, being overweight EM generally means being overweight BRICs and that’s not a good play at this point in the cycle.
  4. Australia and Canada come under pressure. These countries are seen as the clean dirty shirts because of their macro fundamentals. The truth is that they have a lot of economic exposure to China and the US. With bubbly housing markets in both countries, i expect the synchronised global growth slowdown to hit these economies harder than most.

BNN link below: In the clip, I am less worried about Europe and am less bullish about the housing data than Ryan is. Europe is a known issue. The risk is to the downside because of policy uncertainty. But the present malaise is priced in. On housing, the data are a good thing for the likes of BofA. But let’s wait for seasonally unadjusted follow through from the March or April Case-Shiller data we get in the spring.

Click for VIDEO.

This post originally appeared at Credit Writedowns and is posted with permission.

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