After the release of the asset quality review yesterday, analysts had time to digest the information and form a modicum of market opinion prior to Monday’s market opening. I give the European authorities credit for releasing reams of information on a Sunday so the market would not be merely reacting to headlines and tweets and could actually trade on substance rather than fluff. The FED could learn a great deal about how to disseminate information from the European authorities. Yes, I know that the results were leaked on Thursday or Friday but the leaks were not significantly market-moving events. The market’s initial reactions to the 25 undercapitalized banks was a rally in the European equity markets and a short-lived rally in the European peripheral bond markets.
The DAX opened strong but sold off after the first hour and struggled to hold support levels. The selloff may have been in response to falling oil prices, a drop in Italian bond futures or another case of Ebola in New York. Whatever. The stress tests are now over and the European banks as a whole have enough TIER Capital to satisfy the regulators and most of all, Mario Draghi and the ECB. BUT THE KEY QUESTION NOW: WHAT IS TO BE DONE?
1. The ECB has now given its clean bill of health to the banking system but how is money going to be flowing from the banks to the economy? The banks have enough capital so anemic lending is due to a clogged credit pipeline or lack of lending opportunities. Remember, in Europe, banks have a more important role in lending to small and medium enterprises because the European corporate bond market never developed to the extent of the U.S. corporate market. The large banks prevented corporate bonds from gaining a major role because of the banks being protected by politicians in France, Germany and the other large nations. In the U.S., large investment banks were instrumental in underwriting the corporate bond market and were in competition with the commercial banks (to Glass-Steagall ‘s benefit).
The ECB is going to have to unclog the credit system by taking onto its balance sheet many of the poor quality loans that make EU domestic banks reticent to lend to anybody but their governments. This is why President Draghi is pushing for an increase in asset-backed securities (ABS). Bundling the loans into a pool will allow the ECB to acquire huge quantities of PRIVATE LOANS, some good, some bad and warehouse them at the central bank. This appears to be a clever move by Draghi for it provides legal cover for the ECB over Bundesbank fears of the ECB exceeding its legal authority and bailing out sovereign governments. The ECB will claim it is only buying “private debt” in an effort to prevent deflation from taking hold, which is within the ECB‘s mandate.
Today, the central bank announced it purchased 1.7 billion EUROS of covered bonds in an effort to add liquidity to the financial system. Covered bonds are the highest-rated ABS and the ECB will need to be careful it doesn’t drain the best paper from the credit markets. In a Bloomberg article about the bond purchases, reporters Speciale and Marsh, noted, “German opposition to sovereign bond purchases means officials have chosen covered bonds and ABS as the latest tools to help expand the balance sheet.” The article said there is only EUR400 billion of covered bonds that are eligible for the ECB to purchase, out of a total EUR2.6 trillion. If the ECB is going to build a FED-type balance sheet it must find some substandard loans to free the banks from sustaining large write-downs of forced asset sales at market prices.
2. In December, the ECB will have to ramp up its Targeted Long Term Refinancing Operations (TLTRO) so as to get large amounts of cash into the banks by removing as much as possible of troubled debt from the domestic banks. This has to be done with the Bundesbank and Jens Weidmann being ever vigilante about the ECB operating beyond its mandate. President Draghi, with the authority of bank regulator, is going to try an end-run around the German central bank and members of the Merkel government. The fear of deflation is rising in Europe and Draghi is going to have to move fast. When will the markets have a sense of ECB success. Our barometers will be the performance of the European equity markets for if Draghi can achieve his goals the growth story should begin to favor European equities.
I have mentioned many times that Deutsche Bank serves as a barometer of European financials so I offer this technical advice. Deutsche Bank OUGHT not to make a new low from that of the week of July 23, 2012, the price of the NYSE ADR was a low of $27.03. This will be an important key for me.
3. Every investor and trader has to ask this question: Will the ECB and FED allow deflation to establish itself with the huge amount of debt that continues to plague the balance sheets of most of the world’s economies? The answer is NO for the lessons of 1937 populate the minds of economic policy makers in the ECB and the FED. Bernanke preached that the FED would not make the mistakes of the great Depression and Mario Draghi and Janet Yellen are both of that philosophical bent. What can be done to avoid it? I DON’T KNOW BUT THE CENTRAL BANK CHIEFS ALL PROCLAIM TO HAVE MORE TOOLS. Markets always test the policies of the governing elites. Stay vigilant and we will be monitoring market action for hints of stress and possible responses. The stress tests were just the END OF THE BEGINNING.
***My take on the FOMC meeting: The statement will be released on Wednesday at 1:00 p.m. CST with no press conference. In my opinion, the FED will allow QE3 to end but will keep its forward guidance language in the statement. The Bank of Canada recently rid itself of the use of forward guidance but the Fed will not want to scare the markets with too much change at one time. Besides, next week brings the unemployment data so the FED has the luxury of waiting to see the jobs report and thus can be more aggressive at the December meeting. It will be important to see if the FOMC statement mentions the STRONG DOLLAR and/or weak European markets. Draghi can certainly use some help in keeping pressure on the Germans. The issue of the DOLLAR is important because the U.S. currency is officially the purview of the U.S. Treasury and not the FED. The FED has to be careful of abusing its power in an effort to serve its mandates.