The European Central Bank (ECB) surprisingly left rates unchanged at its last meeting on May 3, saying it will continue to assess the impact on the economy of two rounds of cheap, three-year funding for banks, even as growth in Europe is sharply deteriorating?eight eurozone countries are now in recession, while others are struggling to grow. This raises alarms that the bank?s ability to fight the crisis is waning.
Figures released on May 2 showed that the unemployment rate in the eurozone rose to 10.9% in March, a record high since 1995.
That has led to more and more politicians?faced with angry voters rebelling against spending cuts?and policymakers to call for a focus on growth rather than only on harsh austerity measures, which they argue are having detrimental effects.
Last week was dominated by news that Fran?ois Hollande had defeated Nicolas Sarkozy as President of France, and by the astonishingly inconclusive elections in Greece. They gave nobody a mandate, but did firmly remove the mandate from the parties that favour accepting onerous terms on which the country was bailed out earlier this year.
ECB?s Mario Draghi has even argued in favour of a ?growth compact? to complement the ?fiscal compact? signed by most European Union countries in March. That agreement is aimed at keeping budget deficits under control, but critics argue that turning to fiscal austerity in a downturn only leads to lost prosperity.
While it seems almost intuitive to reduce the debt-to-GDP ratio by making the numerator of that fraction smaller, the downside is that reducing that numerator also lowers GDP, the denominator.
Yet there is a strong view among ECB members that additional ECB action at this stage would not make a material difference. ECB has also seen signs that its liquidity support for eurozone banks has started to ease constraints on the supply of credit to the real economy?even if it has not compensated for weak demand for loans from business and consumers.
Meanwhile, eurozone inflation, at 2.6% in April, remains significantly above ECB?s target of an annual rate ?below but close? to 2% and is not expected to fall below 2% until next year. In Germany, worries are growing that ECB interest rate policy is too loose?and will fuel price pressures. The Bundesbank has expressed concern about the pace of house price rises.
ECB?s funding operations, launched in December 2011 and at the end of February 2012, were welcomed by many analysts, who argued that they stabilised Europe?s banking system and prevented a credit crunch. They enabled banks in troubled periphery countries to access funds.
German Chancellor Angela Merkel has maintained her opposition to more stimulus to boost the eurozone economy, and this has already created tension among ECB board members.
A sharp rise in peripheral bond yields in recent weeks?in particular for Spanish government debt after S&P downgraded the country for the second time this year?has left many bond market investors wondering whether ECB will step in to calm markets.
In my view, ECB will not hesitate to intervene again should market tensions increase further. However, not all ECB tools are as sharp as they used to be.
Take, for example, the SMP programme (ECB?s bond-buying programme). Since the Greek haircut, markets sense a two-tiered market when ECB steps in, probably requiring ECB to increase its efforts to achieve similar effects as in the past. The second LTRO was probably the end of the easing cycle.
The simple sad fact is that buyers of last resort are dwindling as the banks lose their deposits to the core, cover their own significant redemption needs, and struggle to choke down more sovereign (carry) debt?all the while leaving an ECB unable to directly enter the primary market (hence George Soros?s recent SPV financial engineering workaround to enable this).
Investors, though worried by Europe?s lack of growth, are wary of seeing the focus shift away from austerity, and warn the mounting growth-versus-austerity debate could keep upwards pressure on Italian and Spanish yields.
Another threat comes from Greece?s uncertain future as a euro member after inconclusive elections. Fitch Ratings warned on May 11 of downgrade risks for a number of countries, including Spain and Italy, if Athens were to leave the euro.
Besides these uncertainties, there are incremental challenges critical to the imminent heavy dose of Spanish and Italian bond auctions:
1. Bid-to-cover is a redundant statistic in these bond auctions as a plethora of bidders (e.g. basis traders?note the current basis is +19bps, which posits ?selling? bonds not ?buying? them, which means the auction would have to come dramatically cheap to secondaries to make it attractive for the hedges) would be willing to pick these bonds up at extremely high yields should they trade there (e.g. how much would you bid at a 30% yield? 40% yield?) and in no way reflect real money?s risk appetite;
2. Every time ECB steps into the secondary Italian and Spanish bond market via its SMP programme, it subordinates investors? freshly minted bonds (via its Greek-related unwillingness to take a haircut);
3. It?s all about the yield?if these bonds come cheap to secondaries and notably beyond the previous auction then that is the critical signal of what is being anticipated and given the rapidly diminishing bucket upon which the Spanish banks can draw to fund their domestic symbiotic partner, I suspect it will not be pretty;
4. Considering the huge volume of borrowing coming up (?46 billion over the next three months), I suspect Spanish banks will prefer to keep a little more dry powder than blow it all on their sovereign purchases at one shot;
5.Cheap European Central Bank?s three-year loans have fed demand for similar-dated, high-yielding government paper. Funding is more challenging for riskier, longer-dated bonds.
While, throughout the crisis, ECB has acted as the eurozone?s fire brigade, even the fire brigade can reach its limits.
Draghi?s support of a growth compact is no escape from the fiscal compact?I see it as only a hidden distress call.
The author is CEO, Global Money Investor