As we head into the second auction of 3Y funds from the ECB (results announced tomorrow), markets remain in a positive frame of mind.
Bond yields in Italy are near the lows of the year, stock markets remain bullish (Euro Stoxx 50 up nearly 10% year to date) and the euro is firmer against the dollar, even though S&P announced Greece was in selective default. Video:
Despite this bullishness, it’s become apparent that sentiment is still uncertain regarding this week’s 3Y auction, with both bullish and bearish cases being constructed around high and low outcomes for the total allocation of funds (see our blog of last week ‘The ECB’s LTRO dilemma’).
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There’s clearly a risk of a classic ‘buy the rumour, sell the fact’ scenario around the ECB auction.
Commentary
The ECB sits back for a second week. The ECB has sat back from purchasing bonds in its bond-buying program for a second consecutive week. This is not that surprising given the developments we’ve seen in markets, with Italian yields pushing back below the 5.50% level from above 7% in the early part of January. Whereas the programme was initially supportive for peripheral markets, there is an opposing force at work. The ECB has given itself assumed preferred creditor status so the more it buys, the more the remaining private sector investors fear having to carry the burden of any eventual restructuring. The larger the ECB’s holdings, the bigger and more valid is this fear. From the ECB’s perspective it is probably more comfortable with the 3Y repos doing more of the work of calming the markers, knowing that this fits more comfortably with its policy remit.
Turning the eurozone lending tide. There is an interesting discrepancy between what ECB President Draghi wants to happen with the funds and what the data says is actually happening. Over the weekend, Draghi stated that he wanted the banks “to expand credit in the real economy”, which he underlined was the primary intention. As the ECB’s own analysis showed, bidding in the first tender was closely correlated with bank re-financing needs. Again, as Draghi has admitted, this probably served to stave-off a credit crunch in the eurozone, as he noted in comments at the January Davos meeting. But it’s going to be a big change for banks to start to lend out further cash borrowed this week. Firstly, this would mean reversing the trend of the past six months of a fall in the pace of credit-growth in the non-government sector. Although headline M3 data for January yesterday showed lending rising from 0.4% YoY to 0.7% YoY, there was a sharp fall in the pace of mortgage lending (from 2.3% to 1.8%) and in the pace of loans to non-financial corporations (from 1.1% to 0.7%). Of course banks are currently reducing the size of their balance sheets to meet the EBA’s capital requirements. As such, asking them to increase lending to the weakening real economy flies in the face of this because, although improved this year, the channels for tapping sources of fresh capital remain fairly limited. Draghi’s wish for more lending is likely to fall on deaf ears.
Accelerating yen weakness. February is turning into the worst month for the Japanese currency for a very long time. At the start of February, USD/JPY was close a record low just above 76. Since then, yen selling has been constant, with USD/JPY reaching a high of 81.67 Monday, a rise of 7%. Tokyo will be delighted. On many levels, the decline in the yen is not a surprise. The crippling loss of production which resulted from last year’s earthquake/tsunami, an overvalued currency which is weighing heavily on the competitiveness of exports and higher energy prices have all contributed to a significant decline in Japan’s trade fundamentals. Japan has recorded a trade deficit in each of the past nine months. Also hurting the currency is the BoJ’s decision earlier this month to lift its asset purchase-program by a further JPY 10trln, as well as the announcement of an explicit inflation target. Traders have been scrambling to reduce significant long yen positions, amplifying the recent currency weakness. In addition, buoyant equity markets have aided demand for risk assets and resulted in a partial reversal of some of the safe-haven demand which had given the Japanese currency such a lift over the last couple of years. And in the United States traders are less convinced that the Fed will actually implement additional quantitative easing given the firmer economic data witnessed over the last few months. It is certainly the case that a 6% shift in USD/JPY in one month is a very significant move. At the same time it should be remembered that Japan is by far the world’s largest creditor, a position made possible by massive sustained current account surpluses over the past quarter century. Although the MoF will be delighted with developments this month, it will certainly have recognised that it is too soon to celebrate. If Europe falls over again the yen will again be regarded as a safe port in the storm.
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