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Is There a Big Relief Rally Under Way?

European Central Bank HQ
The European Central Bank’s new headquarters, still under construction, right, are seen alongside other buildings within the city, across from the River Main in Frankfurt, Germany. Photo by Hannelore Foerster/Bloomberg via Getty Images.

Some might be expecting comment on the State of the Union here, but really, I don’t see much point. I’ve been listening to these speeches for decades now, and they are not policy proposals so much as articles of faith: “Here’s what I believe in. Here’s what I’d like to do.” Then comes the political process, and all the haggling – if not downright obstructionism – that will drastically modify, if not completely keel-haul, anything the President suggested last night.

Liberal commentators like Mark Thoma bemoan a massive short-term jobs proposal, given that some 27 million Americans, according to our own U-7 reckoning, are still un- or underemployed. Conservatives like Greg Mankiw are “disappointed, and even a bit surprised, that the President adopted the xenophobic approach to outsourcing and international trade” and “misleading claims about Warren Buffett’s tax rate.”

The reaction of markets has been positive: The Dow up slightly as of 1:30 p.m.; U.S. government interest rates, down.

Meanwhile, the action remains in Europe, where our own Margaret Warner is now headed. I was particularly struck this week by a fascinating pair of posts on the Eurocrunch.

Here’s conservative pundit Ed Yardeni early in the week:

“There’s a big relief rally under way in European bond and stock markets. The Italian bond yield fell as low as 6.00 % this morning. It was as high as 7.26% on January 9. The MSCI Europe stock price index is up 4.7% ytd, matching the S&P 500’s gain. It is now back above its 200-day moving average.

The point of this data dump is that European cyclical and financial stocks are pointing to better times. Many of them plunged during the second half of last year, but have retraced 50 percent or more of their losses since bottoming in early October. The MSCI Europe index lost 25.4 percent from last year’s peak on February 16 through last year’s low on September 22. Since then it has regained 50.2 percent of that loss, though it still remains 12.6 percent below last year’s peak.

Making Sense

That’s all quite impressive given that S&P downgraded nine euro zone nations on Friday, January 13. In its statement, S&P explained, “In our view, the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the Eurozone.” However, the agency said it believed euro zone “monetary authorities have been instrumental in averting the collapse of market confidence.”

The credit rating agency has turned into a contrary indicator. Recall how well U.S. Treasury bonds performed after S&P downgraded the U.S. government in early August. Financial markets are clearly increasingly impressed with the power of the European Central Bank’s Long Term Refinancing Option bazooka. So are European leaders, who recently heeded the ECB’s warning against backsliding on their commitment to tighten budget rules.

In the Monday, December 12 Morning Briefing, I wrote the following about the LTRO., which the E.C.B. announced on Thursday, December 8: “Could it be that the ECB just became the indirect lender of last resort for European governments by acting so aggressively as the lender of last resort for the banks?” In my opinion, the ECB had just averted a sovereign debt and banking meltdown by agreeing to lend an unlimited amount to the commercial banks so they can do the same for governments at a very profitable “carry” spread.

That was a fairly controversial view at the time. Indeed, when I appeared on CNBC’s Squawk Box on December 12, guest host Neel Kashkari, who oversaw the U.S. Treasury’s Troubled Asset Relief Program (TARP) under U.S. Treasury Secretary Hank Paulson, disagreed with my upbeat assessment. Many other commentators were equally skeptical that the European banks would take advantage of the carry trade by purchasing more European government bonds. Now that the markets have done so well, the consensus seems to be that the ECB saved the day.

Yesterday’s Wall Street Journal included an article titled “Secret Weapon: Europe’s Loan Plan.” The article stated that the LTRO has been more like a stealth bomber than a bazooka. It restored confidence by ensuring that Europe’s banks had access to financing. It forced the shorts in European bonds and stocks to cover their positions. The article reported that banks with the biggest European government bond trading desks are showing interest in profiting from the carry trade opportunity created by the LTRO. I wouldn’t be at all surprised if European leaders such as French President Nicolas Sarkozy quietly remind their friends at the banks that they should buy government bonds as a quid pro quo for the liquidity provided by the ECB, which saved their collective derrières. After the LTRO was announced, Sarkozy told reporters that was his expectation. I dubbed it “Sarkozy’s Moment.”‘

Except for the Y2K “crisis,” which Yardeni warned of loud and long, he has consistently looked on the bright side over the course of his career, including a cheery assessment of the housing market in late 2006 with me and Nouriel Roubini on the sidewalks of New York. Sometimes he’s been right; other times, as in 2006, he’s been rather spectacularly wrong. If investment banker and economist prognosticator Ken Courtis is right, Yardeni is again missing the boat. The Courtis comments were sent to me by Yale historian Paul Kennedy. His 1988 book about (among other things) imperial overreach in general, and U.S. overreach in particular, “The Rise and Fall of the Great Powers,” has sparked new interest in recent years. It begins in debt-ridden 16th century Spain, debt-ridden again (or perhaps “debt-ridden still”) more than half a millennium later. But these days Spain is simply symptomatic of Europe in general.

“We have an ‘interesting’ situation emerging in Europe,” writes Courtis. “Since mid-Nov, the ECB [European Central Bank aka Europe’s Fed] has been pumping money into the financial system faster and on an even larger scale than the Fed did previously.
The tsunami of money has been so large, that during the last week, the ECB balance sheet became larger than that of the Fed, which itself is several times larger than it was before the Bush Bubble popped.

A great part of the money that the ECB had announced a few weeks back for its 500 billion Euro, three-year loan facility, at 1 percent, which they had said was for banks to use to buy government bonds — and so make turn on the spread — has ended up being used by some of the most dangerously weak banks in Europe to rebuild their balance sheets!

How? you might ask, and it is a really good question!

Not surprisingly it was the Italians who ‘discovered’ the ‘loophole’. Was this new ECB facility concocted so that the ‘loophole’ would be ‘discovered’? Whatever, this is how much of this money has ended up refinancing the banks — a sort of EU TARP as it were.

First, the EU banks took out about 500B Euros of this three-year money at 1 percent interest. But as the ECB defined the collateral that could be put up as a counter party to the loans in such a broad way –actually the collateral can include virtually any financial security, except the paper linked to the kitchen sink. (Maybe with a wiggle that could be included as well.) So rather than buying up high-yielding sovereign debt, and capturing the spread, the Italian banks – and others will now follow– issued their own securities and served them up as collateral… So that means these banks now have in place 1 percent financing for the next 3 years! And as it is ECB money, it is considered equivalent to equity!

This gives a whole new definition to “kicking the can down the road.”

It is hard, for me at least, to see the flaw in Courtis’ reasoning. But as I often point out, following John Maynard Keynes, economic vitality is all about “animal spirits,” i.e., optimism. If the ECB can keep the game going, who’s to say how far the can can be kicked?

This entry is cross-posted on the Rundown– NewsHour’s blog of news and insight. Follow Paul on Twitter.

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