Markets had already been on the rise last week on the back of better-than-expected Black Friday retail sales in the United States and some bond auctions that did not fail.
But last week’s positive trend was essentially carried by the announcement of the six most important central banks of the world—the Federal Reserve, the European Central Bank (ECB), Bank of Japan, Swiss National Bank, Bank of England, and the Bank of Canada—providing liquidity to mostly European banks in a global effort.
The Euro Stoxx 50 benchmark equity index gained a phenomenal 10.95 percent to close at 2,342 last Friday, erasing all of the losses from the previous week. The euro currency gained 1.15 percent to close at $ 1.3393 in yet another volatile week, but failed to match the proportion of the gains in stocks. This action breaks the losing streak of the market as participants cheered the global central banks’ intervention.
Data Overshadowed by Liquidity Provision
Economic data came in as expected as eurozone consumer confidence dropped and the CPI came in at 3 percent year-on-year, which is above the medium term target of the ECB of 2 percent. Germany’s unemployment rate surprised a little bit positively, coming in at 6.9 percent in November versus the 7 percent expected.
This data was largely ignored by traders as the market reacted very well to the announcement of the six central banks last Wednesday to reduce the rate at which they charge each other for short-term loans denominated in U.S. dollars by 0.50 percent. In a press release the central banks said, “The purpose of these actions is to ease strains in financial markets (…).”
Central banks use so-called swap agreements to provide liquidity to each other in different currencies. The ECB for example can provide unlimited euro funding to its banking sectors but unlike the Fed it cannot provide dollars and vice versa.
Sovereign Concerns Lead to Lack of Liquidity
European Banks especially have been under pressure, due to their exposure to the debt of ailing sovereign nations such as Italy. If debt goes bad, these banks have to take big write-downs like it happened with subprime loans in the United States in 2007. Write-downs cause big losses to shareholders equity and can in extreme cases lead to bankruptcy, which is what happened to U.S. broker-dealer MF Global recently.
Due to the increased risk, counterparties that usually loan money to said banks become more cautious and do not renew those loans. U.S. money market funds for example did provide a lot of loans to French banks but have recently cut down that exposure. They can usually do this because the loans are short-term in nature. Independent blogger Reggie Middleton estimates “the biggest European banks receive an average of [$64 billion] funding through the U.S. money market.”
This would not cause a problem for European banks if the loans were in made in euros. If that were the case, then the banks in question could just go to the ECB and get funded there until the stress in the sovereign market abates. In fact, the entire Greek banking system has been completely funded by the ECB for several months now and so far there has not been a large-scale bankruptcy.
European Banks Need U.S. Dollars
The withdrawal of liquidity is a problem, however, as many European banks borrowed U.S. dollars to invest in U.S. dollar assets as the ECB cannot provide dollars.
This could be mitigated if the duration of the loan and the investment were matched. If a French bank issues a bond running over 10 years in U.S. dollars and then invested the proceeds into mortgages that also mature in 10 years, the creditors could not ask for the return of the U.S. dollars loaned in the bond issue before the mortgages also mature.
European banks, however, took on a heavy risk when they borrowed the U.S. dollar short term—mostly in the overnight interbank market—and invested long term in many different U.S. dollar assets such as treasury bonds. The creditors can always pull the funding if they think that the risk is becoming too high, but the bank cannot always sell its longer-term asset, as there might be losses to take or no bid at all in the market for more illiquid assets such as private equity. This is called a funding mismatch.
When central banks can swap their native currency for U.S. dollars, this concern can temporarily be alleviated.
Signs of Stress Make Central Banks Act
The euro/U.S. dollar basis swap, an instrument of the interbank market that marks the rate differential between short term U.S. dollar and euro loans was at levels last seen in November 2008, therefore indicating a severe need for dollar funding.
The private market for short-term U.S. dollar loans between banks is reflected in the London Interbank Offered Rate (LIBOR), which has been consistently rising since July 25.
The Week Ahead
This week will be relatively busy as Greece and Ireland will vote on their budgets and France and Portugal will auction off bonds. The ECB will also announce its rate decision on Thursday when Chief European Economist Riccardo Barbieri Hermitte of Mizuho expects another rate cut of 0.25 percent to 1 percent.
Conservative politicians across Europe will meet on Wednesday and there will be a final European Union (EU) summit on Friday. EU President Herman Van Rompuy will probably kickoff a discussion on treaty changes that will facilitate monitoring budgets and spending of individual states.
On the economic front, German factory orders, industrial production, and exports are key to watch as the German economy is expected to shoulder much of the bailout funding for the periphery.
