Floyd Norris has an interesting piece in the NYT today about the ECB’s lending operation. Norris argues that the ECB’s three-year lending to banks is effectively a bailout for governments, since banks will use the funding to buy the debt of their own governments and make a risk-free return (except for the risk of government default, but the banks would probably be bust then in any case). He also points out that the ECB is taking as collateral MBS that were rated A at issue — many of which will now be rated as junk. Both sets of measures, Norris argues, should bring in peripheral sovereign spreads and help with the recapitalisation of banks.

I am not sure that Norris’s picture of things is completely right. Why should three-year funding for banks make such a difference, when the unlimited one-year funding that was previously planned for the same date did not? Norris’s argument suggests that banks should now be prepared to buy up to three-year government bonds because their funding is assured for that period — so why have the Italian and Spanish yield curves fallen and steepened in a smooth way since the yield peak reached on 25th November, rather than showing a dislocation at the three-year point? Why have yields actually increased this week, when banks have finally got their hands on the ECB’s money (EUR 489bn of it)? These observations are not consistent with the idea that a strategy of buying domestic sovereign bonds for which funding is assured has suddenly been adopted by the banks and has been the driver of falling peripheral spreads.

What happened in the Spanish and Italian debt markets was that yields began to fall on 25th November on speculation about bond-buying by the ECB, and then continued to fall even after Draghi said that that ECB would not be buying bonds. That means that something the ECB actually did do must have been at least as good as ECB bond-buying in order to justify post-hoc the fall in yields that had already taken place before the ECB meeting and to cause yields to fall further in the following days.

Perhaps it is that the ECB has assuaged concerns about the health of Eurozone banks by signalling its determination to provide them with liquidity. But that idea is also not borne out in the data. Banks are still concerned about other banks’ financial health, as shown by the fact that they continue to demand high-quality collateral for any lending — German bond yields are hitting new lows and repo rates remain at a historically wide discount to EONIA, which shows that banks desperately need collateral for their borrowing, and the picture is confirmed by the EURIBOR-EONIA spread, which remains close to its widest recent level.

If the ECB’s action has not worked either by inducing banks to adopt a yield-curve-riding strategy or by signalling its readiness to act as lender of last resort (something that should not have been in doubt anyway, given its actions during the financial crisis), perhaps it has had some other practical effect. I can think of three possibilities here, all of which take the position of banks, not the position of indebted sovereigns, as having been primary in the recent run-up in peripheral spreads (the primacy of the banking crisis over the sovereign crisis is something Andrew Hunt has talked about for some time). 
  1. It is all about small banks. By accepting much poorer collateral than before, the ECB has given access to funding to a wider range of banks, thereby improving their credit quality in the eyes of the market. This would include small banks that do not contribute to the EURIBOR panel, so EURIBOR has not fallen. The reason for the recent widening of sovereign spreads may have been the ongoing slow-motion bank run in the periphery, which caused the market to fear that governments would have to bail out their banks, something they are in no position to do. By making funding available to small banks, the ECB has offset the run on deposits, stabilised the position of smaller banks and taken the pressure off peripheral sovereigns.
  2. It is all about collateral. Banks have recently come to fear lending to one another. That has meant a rising demand for collateral. As collateral became scarce, the risk of a collateral crunch came onto the market’s radar screen. Peripheral sovereigns stand behind peripheral banks while peripheral banks are the major market for their own governments’ debt, which means that a collateral crunch in the periphery would both have impacted the credit quality of peripheral sovereigns and at the same time reduced demand for their bonds. By lowering its own collateral standards, the ECB eased the collateral crunch, allowing banks to use collateralised borrowing to offset their ongoing deposit losses. That allowed the banks to return to the peripheral debt markets and reduced the chance of peripheral governments having to recapitalise their banks.
  3. It is all about the term. Perhaps three-year funding is qualitatively better for banks than one-year funding. I do not know why this should be so.
Perhaps recent market moves have resulted from a combination of all three possibilities. 

What does this mean for my trades? The fact is that, even if I am not sure of the mechanism, the ECB’s action has reduced Spanish and Italian yields to sustainable levels. That means that the euro crisis may be on hold for now (although I expect further crisis waves as austerity measures cause a nasty recession). Add to this the fact that American economic data continue to surprise on the upside and that my US leading indicator ticked up in November after months of flatlining, and the possibility of a wave of euro-funded money flows into risk assets, and my short on the S&P 500 starts to look suspect. In addition, without further short-term deterioration in the European situation, with the ECB having reversed its silly rate hikes, and with EUR/USD around post-2007 lows (ex. the period of extreme pessimism in 2010), my short on EUR/USD also starts to look less attractive. In consequence, I have closed both positions today.

As a result, I now have no open positions. Since I started at GNA in late July, I have made a realised profit of 7-8% (an approximate figure because I have not been as careful as I should have been about recording my total capital). Since March, when I began to work on the latest iteration of my trading method, I am up around 3-4% (owing to some early mistakes — which I hope not to repeat, since I understand why I made them). I have not had any serious losing trades since I started at GNA and none of my stops have been hit. My major mistake has been to have too great an inclination to hold onto positions. It is hard to get the right balance here: it is hopeless to wimp out of positions at the first sign of trouble. But equally, it is not good to hold positions for too long. Had I taken profits when I decided to hold through October’s rally (which I predicted), I would have been up more like 10% since starting at GN; on a mark-to-market basis, I was up over 12-13% at one point; and had I not held onto the trades, I could have re-entered near the top (on days I identified at the time) and made further profits on the subsequent fall. For example, I have held my short EUR/USD position through thick and thin, and have exited at about the lowest level since I entered the trade; but the price of that approach has been 1) that I got no extra benefit from trading around the position and 2) that I have failed to take good mark-to-market profits on several mediocre trades and then exited at a small profit or small loss. I think that I will change this aspect of my trading method in the New Year — to become more inclined to take profits when they are on offer. I started trading being wrong as much as I was right, and losing money; then I went through a period of being wrong and losing money, which was the most frustrating part of my career so far. Now I hope I am getting the hang of being right and making money. But this is not a game one ever finally wins and I have no doubt that I will have the opportunity to learn from many more mistakes.

Turning to the US, John Boehner has given his agreement to the Senate plan to extend various fiscal measures for two months, putting off a decision about how they are to be paid for. This is good news for the US economy. It also promises more ludicrous theatrics from the US Congress next year. There was some disappointing news on the US economy, with Q3 GDP revised down from 2% to 1.8% in Q3. The change was a result of a downward revision to PCE and an upward revision to inventory investment (reducing the likely impact of any Q4 inventory bounce). An upward revision in the GDP price index from 2.5% to 2.6% presumably also had an impact.


Revised Michigan sentiment rises, b.e. Sentiment is now back to its pre-August levels. This bears out an observation made by various commentators when sentiment first fell, that events with a high media impact can damage consumer sentiment without having a commensurately large impact on consumer behaviour, and that it takes a few months for sentiment to recover.

Next 24 Hours:

Durable goods orders
Personal income and outlays report
New home sales.