The ECB and good liquidity versus bad liquidity
Posted on 25 June 2010
Race memory is a persistent beast. It permeates our language, our food and apparently our central banks. As an Australian, I’m all too familiar with the laconic pragmatism of our Reserve Bank. The US seems to oscillate between a puritan ethos and the robber baron methodology. While the ECB is a relatively new kid on the block, clearly the scars of out-of-control inflation remain fresh given their focus on money supply as the root of all evil.
Why the ramblings? It was this chart that caught my attention:
The DAX and the S&P500 had been matching each other step for step through the equity market surge from the lows – until recently. Maybe the ECB’s disaster recovery plan is working.
So does this outperformance by European equity suggest that the ECB is taking over leadership in the liquidity fuelled risk rally from the Fed? From the ECB monthly bulletin (here):
A key consideration behind the setting-up of the SMP (Securities Market Program) was the inability of certain financial market segments to absorb transactions without much effect on prices. It is this notion of liquidity, commonly referred to as financial market liquidity that the SMP is intended to restore. By contrast, the SMP is not intended to alter banks’ holdings of central bank liquidity, a concept that centres on the ability of banks to pay their obligations with deposits held with the central bank. At the same time, the SMP should not alter the monetary liquidity of the euro area either, which relates to the ability of the money-holding sector to make payments and is commonly measured by a broad monetary aggregate – such as M3 in the case of the euro area.
No one said it would be easy. In short, the SMP is aimed at transferring credit risk from European banks to Eurosystem central banks – ostensibly because the markets for the credit risk in question are ‘disorderly’ – this is what the ECB calls providing ‘financial market liquidity’.
However, the ECB will not condone the SMP resulting in an increase in Eurozone money supply. It will not print money – that’s increasing monetary liquidity. For this reason, the purchase of credit will be sterilized – the ECB will re-absorb the cash received by banks for offloading their paper by requiring that these banks reinvest the cash in term deposits with the ECB.
The objective is then to socialize the price of credit. We can see the dislocation in the European credit markets via the iTraxx Europe Senior Financials credit default swap index (from the ECB’s May Bulletin again):
And zooming in on more recent price action (from Markit Credit Research here – note this is a chart of the 10 yr index). Note that while the equities markets have recently retested their highs, the CDS market remains at elevated levels:
So what then to make of the relative performance of European equities?
Assuming all else is equal, it makes some sense for the financials to become relatively more attractive given that they can offload troublesome debt to their governments. At the margin, their credit improves – notwithstanding the fact that the aggregate credit quality of Europe is unchanged. Trouble with this theory is that the CDS market hasn’t responded like equities have.
More likely is the possibility that notwithstanding the ECB’s best intentions, the credit support operations are leaking back as additional monetary liquidity. The distinction between monetary and financial market liquidity is a grey one. In the everyday running of an economy, banks effectively print money through the credit creation process. While Europe is also subject to the global deleveraging trend, the fact that Euro banks are able to trade bad credit for good, means that at the margin their ability to leverage their balance sheets is enhanced. While the ECB is sterilising the SMP, if I understand it correctly, banks can still use the resultant term deposits as collateral to support borrowings under the ECB’s other funding arrangements. I’m not close enough to the European markets, but when the FT claims that junk bond issuance in Europe has blossomed over recent days (here), the thought that some of the monetary liquidity is flowing back into markets seems reasonable.
Postscript:
Greg at Merrillovermatter made the point that it may be that Germany as an export economy may be benefiting from weakness in the Euro. While the Germany’s trade surplus is weighted heavily towards their trading with other Euro nations (and therefore should be unaffected by the Euro but directly impacted by austerity measures), maybe there is something to this. Following is the daily chart of some more of Europe’s bourses (the Swiss and French).
5 responses to The ECB and good liquidity versus bad liquidity
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Hi Rohan,
That’s an interesting piece.
Overall, I’m not sure that is a good thing…maybe your title should be bad liquidity and even worse liquidity?!
Hi BK,
Maybe something like … excuse me sir, your liquidity is leaking?
[...] Is some ECB liquidity flowing back into the capital markets? (Data Diary) [...]
You are showing the Dax. I wonder if Germany is outperforming recently due to the weakness of the euro. (Which would assist their exports) How has the Dax compared to a non PIIG non export based euro economy?
Hey Greg,
I admit it was simpler to pull the DAX data and look into the sub-sectors etc. Guess we can look at Euronext (France, Belgium and Netherlands), the Nordic exchange or the Swiss (that given it’s strong financials flavour might be an interesting comparison).
Simply a function of bandwidth at my end…
Cheers
Rohan