The world’s equity markets continue to float on the continued liquidity provided by the world’s central banks. Last week the European markets saw short-term rise on the announced payback of LTRO (Long Term Refinancing Operation), which was money lent by the ECB to European banks to prevent the wholesale selling of sovereign and commercial debt that had fallen in value. The European Central Bank took the devalued bonds and provided the banks with cash euros. This prevented a total collapse of the sovereign debt markets. Now banks that are flush with liquidity are taking back the debt and paying back the EUROS resulting in a short-term tightening in the EURIBOR RATES. Prior to the last ECB meeting, I advised that the ECB could cut rates for the market had already priced in a rate cut. Last week’s action, while a tightening, is actually a market reversing expectations, which is why the global equity markets had so little reaction.
Even U.S. interest rates in the EURODOLLARS rose in response to the LTRO action but not enough to derail the EQUITY markets. What has been removed by the European banks has been replaced by the Japanese policy makers and the FED. The Fed’s balance sheet increased to more than $3 TRILLION in assets as the QE program continued. The precious metals reacted negatively to the LTRO but I believe GOLD and SILVER were sold as some traders decided to cut back on haven bets and look to put money to work in the comfort of dividend-paying stocks–remember that there is a difference between trading and investing. The EQUITY markets are very complacent in finding consolation on a sea liquidity, which is creating a dangerous feeling of TRANQUILITY.
***There is much talk in the world about the “Global Currency Wars.” Readers of NOTES have been aware of this for many months and even longer when we throw in the analysis of Brazil almost 18 months ago. It was the Brazilian Finance Minister Guido Mantega who fired the first shot in the WAR when he complained about the impact from the FED’s QE programs on the developing economies. Now Bill Gross and the rest of PIMCO are discussing it in every forum. Even Bundesbank President Jens Weidmann is calling attention to the recent action by Japan as a move to heighten the tension of competitive devaluations. This is going to be a theme that continues on through 2013 as many economies attempt to gain a competitive advantage or at least try to maintain some supposed advantage.
Today, a new voice was heard as the New Zealand Herald had a story about N.Z. manufacturers and union leaders complaining that the KIWI‘s strength is beginning to result in a loss of jobs. Even an agrarian/commodity-based currency feels it is being adversely affected. New Zealand-based manufacturers are threatening to move jobs to other countries to offset sales lost to the Kiwi’s strength. The FED‘s policy of QE is impacting the global economy in many unpredicted ways–playing with the world’s reserve currency leads to massive financial distortions. Everybody in the liquidity pool … except Draghi and the ECB for the moment. The ECB has not had to invoke an OUTRIGHT MONETARY TRANSACTION … yet.
When that moment comes it will be a major catalyst for the currency markets, which is why the European yield curves will continue to be our most important barometer. Any selloff in the Italian or Spanish two-year note that leads to a flattening will be our warning signal. Until then let the animal spirits lift all boats and remember that markets can remain irrational far longer than you and I can remain solvent (KEYNES).
***A quick update on the Cyprus banking situation. There is no doubt that the Cypriot banks are under severe strain and it is only an issue because Cyprus is a member of the EU and the euro. The Cypriot banks are the home to the money of many very wealthy Russians and thus Putin and Co. want the ECB to stand behind the banks by supplying the needed liquidity as they did for Greece. There are discussions of having Cypriot bank depositors take a haircut on their accounts–Europe has no deposit insurance program in place–as a way to punish the Russian oligarchs who have so much at risk. This is going to be a continued controversy and is more politics at this point than financials due to the size of the bailout. It will be of interest to see what cards Russian President Putin will play in order to protect his cronies who have much capital at risk. Let’s listen for noise about cutting off the flow of energy from Russia to Europe. This is a game of MORAL HAZARD CHICKEN … who will get paid?