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ECB Draws a Line in the Sand for Euro at $1.400Gary Dorsch Two years ago, the big worry in the global markets was the possibility that Greece would opt to leave the Euro, which in turn, would set off a chain reaction, in which Portugal, Ireland, Greece, Spain, and Italy might also choose to do the same. The Euro’s credibility was at risk as it plummeted towards US$1.200. Nervous investors were thinking about withdrawing monies held on deposit with European banks. A mini-flight of capital was already underway. Businesses and households had withdrawn €80-billion ($103-billion), from banks in Greece, Ireland, Italy, Portugal, and Spain, during the first five months of 2012. Earlier, in December ’11 and February ’12, the European Central Bank (ECB) injected €1.1-trillion of excess liquidity into the banking system, with 3-year loans, in order to create a buffer for Europe’s biggest banks against the threat of deposit flight. The ECB’s actions helped to calm financial markets for a few months, but the relief was short-lived. Doubts about the health of Spain’s banks and questions over Greece’s future continued to linger. Foreign investors were convinced that Greece, Ireland, and Portugal could not survive their crushing debt loads. Their debt-to-GDP ratios were high enough to make a default a serious possibility. Madrid had already asked for €100-billion in rescue loans to prop-up Spanish banks. Spooked about the possibility of a break-up of the Euro, foreign investors had already dumped €242-billion worth of Italian bonds, lowering their exposure to 35% of bonds outstanding in May ‘12, compared with 51% a year earlier. Foreign investors also slashed their exposure to 26% of Spain’s bonds, from 40% a year earlier. Belatedly, the rating agencies weighed in with their opinions. S&P cut Spain’s sovereign credit rating to BBB-minus, or 1-notch above junk territory, citing a deepening economic recession. Moody’s also issued a Baa3 rating, and put Spain on review for a possible downgrade. S&P lowered its long-term sovereign credit ratings for Italy to BBB from BBB+, or two notches above junk status, citing the size of Italy’s public debt which is today is 132% of gross domestic product, the second highest in the G-20 world, behind Japan. However, the banks in Italy and Spain took a contrary position, and were acting as lenders of last resort for their governments, and ended up as the biggest winners from the crisis. Spanish banks borrowed more than €300-billion from the ECB, and plowed much of the money into Spanish government bonds. Likewise, Italian banks borrowed €255-billion in ECB loans, between late 2011 and early 2012, and used it to buy sovereign bonds. As a result, Italian banks controlled 57% of Italy’s marketable debts, and Spanish banks owned 67% of Spain’s marketable debt by the summer of 2012. Without the ECB’s “backdoor QE” scheme, borrowing costs for Italy and Spain could’ve spiraled sharply higher, like in Greece, and increased the odds of a default - on the very bonds held by the banks. As such, the Spanish government and Spanish banks became perilously co-dependent, in what was called a “doom loop,” in which frail banks and troubled debtors states recycle the same money to prop each other up. However, the difference between the return offered on the sovereign bonds and the low cost of borrowing from the ECB generated enormous net interest income and spectacular capital gains for the Italian and Spanish banks. In Kaiserstrasse, the Frankfurt home of the ECB, Mr Draghi delivered a clear message, “If we are to do an operation similar to the LTRO, we’re going to make sure this is being used for the economy. And we’ll make sure this operation is not going to be used for these “carry-trade” operations.”
A Greek exit from the Euro currency could’ve opened-up a “Pandora’s box,” and left the door wide open to other disasters. Europe’s biggest banks were still sitting on $1.2-trillion worth of debt issued by Spain, Portugal, Italy, and Ireland, and nursing huge losses, and with traders piling up bets on the break-up of the 17-country Euro currency bloc, the situation looked grim. On May 9th 2012, the Euro Stoxx Banks index, a basket of 30-Euro-region banking stocks tumbled below the depths of March of 2009, “Great Recession” lows. The Markit iTraxx Financial Index of credit-default swaps on the senior debt of 25 European banks and insurers reached 308-bps, matching the highest since the days before the ECB’s first offering of 3-year repos. The Euro fell to a 21-month low against the US-dollar. However, on July 26th, 2012, with 23 ad-libbed words, ECB chief Mario Draghi changed the course of the Euro-zone debt crisis. “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough,” he warned. It was a master stroke. Draghi never needed to back up his tough words with action. Draghi’s “Jawboning” proved to be a game changer, - it took the systemic risk out of the Euro-zone’s financial markets with the ECB implicitly guaranteeing the bonds of the troubled debtors in the Euro-area, and thus, reducing the likelihood of a break-up of the Euro. Today, the ECB can look back and rightly claim to have staved off a financial disaster. The ECB’s pledge made on Sept 6th, 2012, to throw its unlimited financial clout behind an effort to protect Spain and Italy from financial collapse by pledging to buy their bonds on the secondary market, was enough to ultimately drive Italy’s and Spain’s 10-year bond yields dramatically lower. Since then, Italy’s 10-year borrowing cost has dropped a stunning -325-basis points (bps) lower and Spain’s tumbled -450-basis points lower, from their peak crisis levels. The nightmare scenario was averted. Subsequently, sharp declines in Greek, Irish, Italian, Spanish, and Portugese bond yields, fueled a huge +60% increase in the market value of the Euro-Stoxx index fund, (NYSE ticker; EZU), to above $42.50 /share in New York. On April 10th, 2014, the ruling politicians in Athens celebrated the return of Greece to the global bond markets. Crazed investors placed €20-billion worth of bids to buy €3-billion of 5-year Greek notes, even though Moody’s rates Greece’s at nine notches below investment grade at Caa3, and S&P and Fitch rank Greece’s debts at B-. Still, buyers accepted an interest rate of 4.75% on the 5-year note issue. The ultra-low interest rate signals a supreme level of confidence among investors that the ECB would act to backstop the bonds, if necessary.
Currency carry traders decided to hop on the bandwagon, by borrowing monies in Japanese yen and US-dollars, and plowed the cheap cash into high yielding Euro-zone bonds. Carry traders bid-up the value of the Euro’s exchange rate to above ¥140, from less than ¥100. The Euro rebounded +16% against the US$ to as high as $1.3950. These leveraged bets helped to depress the yields on Italian and Spanish bonds to within spitting distance of yields offered by British Gilts and US Treasury notes. Also bolstering the Euro’s advance is a tightening of liquidity conditions in the Euro-zone’s banking network. Over the past two years, banks have repaid more than €700-billion of the ECB’s 3-year repo loans (LTRO’s). Excess liquidity, - the amount of money beyond what banks need for their day-to-day operations - fell to €86-billion this week, the lowest since late 2011. Excess liquidity peaked at €804-billion in early 2012. As a result, the Euro is buoyant, and bumping up against the psychological US$1.40 level and hovering above ¥140. To read the rest of this article, please click on the hyperlink located below; http://sirchartsalot.com/article.php?id=190 ### May 1, 2014 321gold Ltd |
