The talk about the ECB firing its ‘big bazooka’ has become ever louder this week, but it’s not the golden egg that many are perhaps expecting. When the BoE undertook QE, it was keen to buy from non-bank holders of gilts in the hope that, in order to achieve portfolio balance the cash would be invested in other assets (such as corporate bonds, equities etc.).
This is unlikely to be the case for the ECB, because it’s the banks where the problems lie and banks own a higher proportion of troubled sovereign debt than was the case for the BoE. For the UK, bank exposure to gilts was around 15% of equity according to BIS figures. In Italy, it’s nearer to 70% and Spain 55%. So, if the ECB did have a big bazooka and wanted to use it, it would invariably aim it at buying debt from the banks themselves. The question is what happens then? It’s likely that banks will use the cash for balance sheet repair, keeping in cash or near cash.
Germany could be one of the main beneficiaries of this, seeing yields pushed every closer to zero or below. QE in a monetary union will be a very hard thing to control and police and the ‘core’ could well benefit more than is currently believed.
Guest post by FxPro
Commentary
Basic basis stress. One of the standout themes of this week has been the growing strain evident in euro funding markets. During the depths of the credit crisis it was the Libor-OIS spread that was often used to measure the extent of this, in other words the difference between having to take on overnight credit risk and 3mth credit risk (will the bank be around in three months?). But 2008 was also the time when cross-currency basis swaps ballooned as well. A basis swap is the exchange of floating rates in two different currencies and in this type of swap, principle amounts are also exchanged, which creates the credit and counterparty risk. It’s a way for banks to obtain liquidity in a different currency, without exposing themselves to exchange rate risk. Generally, before the credit crisis, there was a modest premium on dollar funding. In other words, you had to pay a few basis points to swap into dollars over and above the rate implied by forward rates (which in turn are based on interest rate differentials). But this difference has ballooned out in recent weeks, from around -30bp in the middle of the year to near -130bp now. There’s been a similar, although not as extreme, move on dollar-yen basis swaps as well. What is notable is that so far this has not had a dramatic effect on the currency, but is likely to be behind some of the recent weakening of the euro. Together with what we are seeing in bond markets (increased signs of stress and forced selling), the deterioration in basis swaps is another illustration of the increasingly dysfunctional markets we are seeing in the eurozone, with little scope for improvement as calendar year-end approaches and liquidity declines even further.
The pain in Spain. Ahead of critical national elections this weekend, there has been no let-up in the relentless pain being suffered in Spain. Bond yields soared again yesterday, the 10yr climbing another 35bp to 6.71%, a spread to Bunds of 485bp. The economy is almost certainly back in recession, unemployment is well above 20%, and it is unclear whether the regional governments are doing enough to uphold their commitment to balance their books. Furthermore, it is highly likely that Spain will be the latest troubled member of the eurozone to change government, after both Italy and Greece appointed ‘technical’ administrations over the past fortnight. Thankfully, both major political parties accept the need for fiscal discipline. However, Opposition leader Rajoy, who enjoys a healthy lead in the polls has not been particularly forthcoming in terms of how he intends to implement more fiscal austerity – indeed, he has committed to maintaining health care and pensions (critical to solving Spain’s fiscal overrun), and has been fairly mute on labour market reform, which lies at the heart of Spain’s lack of competitiveness. An additional issue is that the national government has very little control over spending decisions at the regional level, where unpleasant fiscal surprises continue to emerge. Should Rajoy taste victory, he will need to adopt the rhetoric of fiscal discipline and structural reform very quickly, or else his country will run out of time.
UK consumer responding to discounting. Keen to revive a consumer which had become moribund over recent months, the promotional campaigns undertaken by the major retailers seems to be having some effect, notwithstanding the fact that consumer confidence is absolutely dreadful. In October, the volume of UK retail sales rose 0.6% last month, after a 0.5% increase in September. How long this lasts remains to be seen, as household balance sheets remain under intolerable pressure. That said both consumers and the Bank would be pleased with recent signs that inflation is moderating – retail prices were up 0.1% in October, after a 0.3% increase in the previous month. Partial justification therefore for the latest inflation forecasts from the Bank of England, which claims that prices growth will slow very sharply next year.
Easier policy in China on the way. China’s officials are likely to ease their policy stance in the next few months as the economy loses momentum and inflation pressures moderate. Growth over the next couple of quarters is likely to dip below 9%, hardly a catastrophe but still synonymous with a slightly softer growth profile. Export growth – especially from Europe – has visibly weakened and house prices are falling in the major cities. Should external conditions worsen, then Beijing will look at its various policy options. It has a strong hand; reserve requirements have been raised very significantly over the past 18 months, key interest rates have scope to be lowered and fiscal policy could be eased through both tax cuts and higher spending. Worryingly for the West, this policy backdrop will likely trigger some hesitation in terms of allowing the currency to appreciate further. With the US Presidential campaign for 2012 already underway, there can be little doubt that the undervaluation of the yuan will again be in the spotlight, especially if the pace of appreciation slows.
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