The European Central Bank (ECB) measures taken in December to alleviate funding strains for the eurozone banking system are unlikely to be as effective over the medium term as originally hoped, nonetheless they will likely continue to provide near term support.

To recap, two major measures were taken: 1) a reduction of 50 basis points in the cost to banks obtaining U.S. dollar funding through the ECB, and 2) the announcement of two 36-month refinancing operations, designed to provide unlimited long term funding to banks. The first measure looks to have considerable success. 34 banks obtained $50.7 billion in three month loans from the ECB at the first 3-month U.S. dollar tender since cutting the penalty rate; that compares to prior expectations by analysts of $10 billion being demanded. This highlights the incredible demand by eurozone banks for dollar funding and the move away from euro funding, a trend unlikely to reverse nearterm.

Even after the ECB announced the 36-month lending to banks in euros (with a lowering of acceptable collateral), banks still appear to be demanding dollars (witnessed in ongoing widening in the euro-dollar cross currency basis which shows the cost banks pay for U.S. dollar funding). Other indicators also highlight that funding pressures remain elevated in the eurozone interbank market. The euro libor-OIS (overnight index swap) spread – an indicator of short term interbank funding stress – remains at the post financial crisis highs. In reality, the market for unsecured funding between banks is shut with banks nervous to lend to other eurozone banks for even just 3 months. The first ECB auction of 36-month liquidity is on Wednesday and is expected to attract considerable demand by banks. With interbank funding closed, the ECB is quickly becoming the only avenue for banks to source funding. Medium term financing by the ECB should reduce the threat of an imminent bank failure but improving investor confidence in bank solvency will likely require lower yields on troubled eurozone sovereign debt. Overall, the threat of a disruptive banking event has reduced in the short-term, but the lifeline of medium-term liquidity support will likely not be enough to re-open the interbank unsecured funding market.

While direct purchasing of sovereign bonds by the ECB remains low, the above mentioned non-standard measures adopted are encouraging banks in Spain and Italy to purchase their respective sovereign - a 1% financing cost by the ECB for 3-years to purchase a 3-year Spanish bond yielding at the time over 5% is apparantly incentive enough. In Spain, yields on one-year bonds have dropped by 120 basis points on the week, with two-and three year maturities dropping by around 100 basis points. In Italy, the reaction has been somewhat more on the muted side, but nonetheless the fall in yields at the short end of the curve has been of the order of 50 basis points or more. Equally, the local investor base in both countries continues to support the new issuance market quite well.

For 2012, one of the increasing concerns is around the “wall of funding” that is due to hit the bond markets. Sovereigns and banks alike have a large amount of debt falling due in 2012. In sovereign space, the approximate number is in the region of €1.5 trillion. This includes the core countries; for the peripherals the number comes to about €600 million. To add in the number for banks is less simple, because quite a proportion of 2011’s funding has been postponed to 2012. Likewise, banks may choose to defer some of their required funding if market conditions remain as challenging as they are at the moment. That said, expect a number in the region of €800 billion for the banking sector.

On the face of it, these numbers do present an obvious threat. It should not be viewed in isolation, however, they are gross, not net. That means that it is entirely conceivable (or it certainly would have been under normal market circumstances) that the majority of the funding will be rolled over by existing holders using the proceeds of their matured holdings to buy the new issuance. Of course, this may prove to be a challenge if the market remains in frozen mode throughout 2012, but the greater challenge for the issuing community would be to ensure that there is no significant addition to the amount to be issued. In other words, austerity should be seen to be working. Furthermore, the success or failure of the peripherals’ issuance programme seems crucially dependent on the continued support of the local (domestic) buyers. The final weeks of 2011 have been encouraging in this respect. Over the weekend, Belgium suffered a less-than-surprising credit downgrade from Moody’s from Aa1 to Aa3 – two notches. This action was signalled in October of this year. At the same time, Fitch has placed France’s AAA rating on downgrade watch, citing not only the generally challenging economic environment, but also the contingent risk of balance sheet expansion/ deterioration. This last point was perhaps missed by those who have pointed out recently that the debt dynamics of France are on a par with the U.K. The U.K. has already suffered the addition of unexpected liabilities through bank nationalisations. France faces the possibility not only of having to support banks (an outlier possibility at this stage), but the additional risk of expanded fiscal responsibilities in the form of participation in the European Financial Stability Facility and the European Stability Mechanism (far less of an outlier outcome). There is no immediate reason for any other agency to follow Fitch, but the groundwork has been laid by particularly Standard and Poor’s for a single notch reduction in the near term.

While attention remains on the ECB, a major story in 2012 is likely to be the policy actions of the People’s Bank of China (PBoC) and how aggressive an easing cycle it adopts in the new year. The recent decision to reduce the reserve requirement ratio (RRR) for large banks by 50 basis points was seen by Chinese equity markets as being insufficient to ease concerns of a slowing economy, a falling property market, and the ongoing threat of a hard landing. Importantly, Beijing’s top priority for 2012 will shift from inflation to maintaining stable growth, engaging in further policy easing in the face of a continued European maelstrom, as commented at The Central Economic Work Conference on 14 December. Monetary policy tools (cutting the RRR and likely increases to banks’ loan quota to RMB 8-8.5 trillion), tax cuts to support small- and mediumsized businesses, fiscal spending targeting middle income earners via social welfare – China has ample tools with which it can maintain and sustain GDP growth at around 8%.
Further, some economic developments, such as the fall in foreign direct investment in November (the first decline this year) need not be interpreted as bearish signals. Rather, it signals to both investors and to domestic policymakers that continued Chinese economic success rests on a gradual rebalancing towards domestically driven investment and an expanding domestic consumer base (including reducing income inequality), instead of driven primarily by export growth and the boom in fixed asset investment. Investors as yet are unconvinced this transition will be both easy to facilitate and occur in time to offset a hard landing. A more aggressive easing stance by the PBoC in early 2012 will likely still be the tonic required to give investors confidence that the China growth story remains intact.

And so it’s time to close on a remarkable year by any measure. One that, like 1968 and 1989, will have a significant influence on politics and economics in the years that lie ahead. We have to recognise that even our expectations for a slow paced recovery in equities and commodities in 2011 have proved (in the main) optimistic. That was clearly down to not just a painful resistance by the private sector to respond to the stimulus of ultra low interest rates but principally to the inability of policy makers to set down a stable medium term framework for investment to emerge. Twelve months ago, we did identify the biggest risk ahead to be a policy mistake – well, we have had them in abundance. The euro sovereign crisis is but one example of where politics is struggling to deliver ‘good outcomes’ in a developed markets’ context of stagnating activity. The consequent loss of confidence is now having a very real impact on growth and we are desperately in need of a clear steer as to what choices societies are prepared to take or more courageously democratic political leaders are prepared to take for them.

We will close on the broad advice delivered as part our Year Ahead programme ‘once again, ..., we advise clients to focus on quality, yield and diversity. Investment portfolios should be positioned to allow critical longer term growth themes to be captured while ensuring that the risk being carried is consistently in line with their stated objectives’.

This is the last edition of 2011, returning on Tuesday 3 January 2012. We wish all our readers a wonderful festive season and a happy New Year.


source: Bank of America ML