A lender of last resort for banks, but not for governments
Willem Sels (pictured), UK Head of Investment Strategy at HSBC Private Bank, on last week’s ECB meeting…
The European Central Bank (ECB) last week provided the expected 0.25% rate cut and came to the rescue of banks, but not Eurozone governments. It gave a big boost to banks, by agreeing to provide longer term liquidity against a broader set of collateral. Senior bonds of better capitalised banks in core Europe may benefit from the ECB’s decision. On the sovereign debt side however, liquidity risks are still substantial.
We do not share Mr Draghi’s view that European governments’ efforts to cap their deficits (a long term process) will be enough to keep markets (with daily trading) from testing sovereign bond valuations: more liquidity support needs to be provided, and the European rescue vehicles may not be the ‘bazooka’ that markets are waiting for. As a result, we maintain our preference for investments in core Europe.
The ECB’s focus has traditionally been to provide liquidity to banks, and it increased this commitment even further by agreeing to provide unlimited 3-year liquidity to the bank sector. The range of collateral that can be delivered has been extended: going forward, asset backed securities with a minimum rating of A and bank loans will be accepted.
This should allow banks to stop worrying too much about liquidity, and focus instead on re-building their capital base, as stipulated by the Basel III, European and local requirements.
During the Q&A session, Mr Draghi made it very clear the Treaty rules do not allow the ECB to lend to governments, and that they should respect both the letter and the spirit of that treaty. This implies that the ECB is unlikely to lend to governments, or to the IMF as an indirect way to lend to Eurozone governments. He repeated that a good agreement from European leaders in Brussels would
not necessarily change his stance much.
The ECB, of course is already buying some government bonds, under the label of ‘monetary operations’ , but ECB officials already stated that the current pace of EUR 20bn / week would not be raised going forward.
The fifth summit to save the Euro focused on increased fiscal integration, to make sure government deficits would not derail again in the future. The rules of the ‘fiscal compact’ state that Eurozone member states’ general government budgets should not have a structural deficit exceeding 0.5%, and a current deficit greater than 3% will automatically be sanctioned by the European Commission and European Court of Justice unless a qualified majority of member states is opposed.
The details of any liquidity support remained sketchy. The European Stability Mechanism (ESM) will be brought forward to be operational in mid-2012. European leaders also agreed ‘to debate’ whether or not to increase the ESM’s EUR500 billion fire- power, but Germany has traditionally been against this. Germany still opposes any ECB support for the ESM, and does not want the EFSF and the ESM to overlap in time to combine their forces.
The leaders also agreed to provide the IMF with EUR200 billion, for which details should become clear in coming days.
Even if some of these funds are levered up, markets will probably continue to worry that the funds may not be enough to provide liquidity to all stressed sovereign bond markets.
In essence, the fiscal compact may have reduced the solvency risk for Eurozone sovereigns (the risk that sovereigns’ debt burden becomes unsustainable), but we believe that it has done too little to address liquidity risk (the risk that a debt auction fails or a coupon is not paid in the short term). Mr Draghi believes that liquidity risk will automatically decline when markets realize that solvency risk has declined, but the recent spread moves for short dated French debt, where solvency risk should be low, proves otherwise, in our view.
It seems very difficult for the ECB (and the German Bundesbank, which wields significant power) to overcome its objections to lending to sovereign states. The Treaty is clear in this respect, and we believe that support will continue to be limited to the ‘monetary operations’ in the order of EUR20 billion per week. It seems unlikely that the ECB will agree to quantitative easing – as done by the Federal Reserve and the Bank of England – unless market conditions spiral out of control.
This leaves the EFSF, the ESM and the IMF as the potential providers of liquidity. Unsurprisingly therefore, when a Chinese official mentioned that China may be looking to invest EUR300 billion in the US and Europe, markets jumped, albeit only temporarily (to be sure, this support does not seem to have been confirmed).
In summary, we believe that there will continue to be plenty of difficult moments ahead when Italy, Spain and other states have significant bond auctions in coming quarters. These auctions can test market sentiment at any point, and without more liquidity support, there is always the risk that one of these auctions fails, and spreads spike.
In our view, sovereign spreads will remain volatile after this summit, and we continue to prefer German Bunds over peripheral debt. The Treaty needs to be voted on, and the details of any IMF, EFSF and ESM support are still unclear, leading to continued uncertainty. This should keep the euro volatile.
Even if sovereigns avoid a liquidity crisis, the required fiscal tightening is highly likely to lead to a recession in the Eurozone, with the potential of a negative spiral of consumer and business confidence. Banks, too, are likely to deleverage further to satisfy capital requirements, further weighing on growth.
As a result, a positive reaction to the European summit is unlikely to be sustainable. We believe that the US and Emerging Markets continue to have a superior growth outlook for the short and medium term.
As for banks, the additional help from the ECB may have reduced the ‘tail risk’ and should help support risk appetite. However, this better sentiment may be limited to the most senior part of the capital structure – i.e. senior debt, rather than equity. The EBA stress tests for European banks illustrate that banks still need to add EUR115 billion of capital, which we estimate is the equivalent of a couple of years of earnings for the sector. This seems manageable for the sector as a whole, given the three year liquidity now provided by the ECB, but of course, the banks who need the capital are not necessarily the ones that generate the most profits.
Finally, sterling may experience some volatility in the short-term, as investors question the wisdom of the UK ‘veto’, and its potential impact on the coalition. However, we believe that GBPUSD will mainly trade in sympathy with EURUSD.
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