The more I think about the European situation, the more I think the ECB has solved the problem for the time being. As I wrote on 5th January, the ECB has begun to expand its balance sheet, and that will allow it to continue to finance balance-of-payments deficits in the Eurozone periphery. Balance-of-payments deficits are the main problem. Austerity in the Eurozone will continue to depress the economy, and may eventually damage the Spanish and Italian economies to the extent that their governments face a solvency problem — but we are not there yet. If Spain and Italy do not face a solvency problem, and the liquidity problem has been solved by the ECB, then the crisis should abate for the time being. Market concerns about the level of bank deposits at the ECB (a necessary correlate of an expanded asset portfolio) and the amount of issuance in Q1 (issuance is generally irrelevant) are a sideshow. If the European crisis cools down, then that should provide room for risk assets to rally regardless of whether the euro becomes a funding currency or not, although the relatively tight liquidity environment should prevent a rally from becoming a sustained bull run.

To develop that idea a little: the US stock market is moved, basically, by earnings and credit spreads. In a liquidity-driven rally, credit spreads tighten and equities rise. Weakness in the liquidity environment does not preclude an appreciation in the market driven by earnings growth. At present, analysts are downgrading their forecasts for S&P 500 earnings, but with the economy accelerating again it is possible that earnings growth could be stronger than expected. Any further strengthening in US leading indicators would therefore provide an argument for buying US equities if an attractive entry point should present itself.

Returning to Europe, the FT’s short view column has pointed out that the ECB increased the number of bond issues on its list of acceptable collateral by a third in December. This goes some way to answering a question I have been wondering about since the ECB’s action but not had time to investigate properly: how much difference did the widening of acceptable collateral make to the situation? The FT also provides some more detail: the ECB now accepts unlisted bonds — i.e. bonds that banks can issue to themselves if they so decide. This will allow them to manufacture collateral for the ECB’s next LRTO, and that is what they are reportedly doing. In terms of the number of bank issues now accepted, the French banks were by far the biggest beneficiaries of the ECB’s move, with 8000 of the 10599 issues added to the list coming from them. Altogether, the picture I currently have of the ECB’s action is that the expansion of its balance sheet has been the most important aspect as far as the euro crisis is concerned, but the collateral and term effects have likely been helpful in heading off a developing credit/collateral crunch. The evidence for this is 1) PIIGS spreads fell while measures of bank stress remained high, so easing funding pressure on the banks was not the most important thing, and 2) measures of bank stress are now beginning to fall (Euribor-Eonia spread, Eonia-Repo spread), so the collateral and term effects seem to have been helpful.

Also on the subject of Europe, it seems that the Greek PSI level is close to being agreed, and it looks set to be 50%. This has again got me wondering whether there might be a trade in Greek bonds, as a hold-out against the restructuring. A serious issue here is the Greek government’s plan to retro-fit existing bonds with collective action clauses, which could force participation in a future restructuring. This is possible because most of Greece’s bonds were issued under Greek law (as an extra protection, the new bonds issued in the present restructuring will be governed by English law). However, there is also an opportunity here: the ECB will probably never participate in a restructuring, which means that one ought to be relatively safe buying issues in which the ECB has a bigger proportion of the outstanding bonds than is required for restructuring under a collective action clause.

Not on the subject of Europe, Mitt Romney has won the New Hampshire primary, as anticipated by the opinion polls. The next state to vote is South Carolina, where the latest polls put Romney well ahead, with Santorum and Gingrich in joint pursuit. Incidentally, I saw the observation this morning that no non-incumbent Republican contender has won Iowa, New Hampshire and South Carolina (presumably since Iowa started voting first in 1976). Since there are only six data points here, I doubt that this observation tells us anything.

Data:

UK trade deficit widened more than expected, Nov. Exports fell and imports rose in volume terms.

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Beige Book
China CPI
UK manufacturing production
Eurozone IP

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