By Lior Alkalay
Senior Analyst, eToro
It was only in February that we learned that the first LTRO initiated by the European Central Bank had been successful at lowering yields on sovereign bonds issued by the Eurozone’s troubled periphery. Now, two months on and only a month after the second LTRO, discussions on the risk of Spanish debt have resumed, this time with a vengeance. Yields on Spanish 10-year Treasury bonds jumped to a new high of nearly 6% and investors are once again questioning the state’s ability to bring its deficit under control.
Europe’s Debt Crisis is Deceptive
In point of fact, Spain has already begun acknowledging its place as the “next” Greece, despite the “success” of the ECB’s two LTROs –the European equivalent of the Federal Reserve’s quantitative easing – which injected more than €1 trillion into the financial system. Those LTROs helped to push through a broad-based recovery in the European equity markets and, indeed, in most European markets. A notable exception, however, was the IBEX 35, Spain’s major index, which lagged behind and underperformed even the Greek stock market. That fact alone added to the 10-year yields on Spanish debt, which remains at elevated levels and clearly signals that the market believes that Spain will be the next domino to topple.
Initial optimism over the ECB’s LTROs is obviously waning and yields in short-term treasuries have started to climb, which is markedly visible in 2-year yields with Spain’s yield recently rising 20 pips right alongside Italy’s. While all of that may signal a real fear of the sustainability of Eurozone debt, the question is does it also signal a possible collapse within the Eurozone over the next few months?
Not really. On the face of it, it is clear that the rise in yields in European debt over the last few months has been more closely linked to the global growth outlook and risk appetite trends rather than budgetary issues in the periphery. This assertion is reinforced by the collapse in bond yields just after the LTRO was initiated. In fact, nothing had fundamentally changed since the yields in Spain and Italy had reached their initial lows and until the spike in yields over the last few weeks. The only real fundamental change was the profit taking and risk-off inflows after a strong rally that began in October.
Fed’s Quantitative Easing Provides Good Insight
For all intents and purposes, the ECB’s LTROs were initiated for the very same reasons as the U.S. Federal Reserve’s several QE schemes, but in either case, a liquidity trap looms. Given the similarities, when studying the after-effects of the Fed’s QE, we can get a rather clear picture of what the European economy could expect and, theoretically, correctly predict the evolving scenario as regards the European debt.
Towards the end of November 2008, the Fed initiated its first round of QE for the U.S. economy, starting with $600 billion, and accumulating close to $2 trillion in various debt papers on its balance sheet. What followed then was a temporary surge in investor confidence but even more than that, the Fed’s QE has actually been transformed into tangible growth as evidenced by the government’s GDP data, which showed a strong recovery in the quarters that followed.
As can be seen in the graph above, the recovery in U.S. economic growth following the Fed’s QE was incredibly strong; GDP recovered from -6.7% in Q4 of 2008 (on a year over year basis) to 3.8% in Q3 of 2009 – a mere two quarters later. It is, therefore, quite likely that the rebound in Eurozone GDP could be somewhat more modest since there is no fiscal stimulus involved, but still we believe the recovery could be rather substantial, nonetheless.
Effects on EUR\USD
One can assume, when comparing the reaction of the U.S. Dollar to the Fed’s QE that the EUR would follow suit with an ECB LTRO and shed its value. That assumption would not be entirely correct, however. One must take into consideration the classic “rule” of the Euro as a risk-on currency and that of the U.S. Dollar as a safe haven currency. Given that, then actual improved growth in the E.U., whether through easing by the ECB or the Federal Reserve for that matter, would result in rising demand for the Euro. Consider, too, the immediate reaction witnessed in the Euro trade following the announcement of the LTRO, which resulted in a strong Euro rise and a gain of more than 5% in the first quarter, then this scenario is in complete contrast to the collapse in the U.S. Dollar’s value following the Fed’s announcement of QE.
Has the ECB provided enough liquidity? Considering that the latest data shows the ratio between the Fed’s balance sheet and the ECB’s balance sheet, one can conclude that the liquidity operations of the ECB have never been that extensive. In other words, stimulus to the Eurozone has never been that aggressive, which is better for economic growth, in general, and for the Euro’s mid-term strength in particular.
Black Swans Await
Although the LTROs will allow European economic growth to gradually recover and keep sovereign budgets generally under control, the biggest risk for the Euro is, in fact, its budgetary behavior. The draconian budget cuts that are being enforced among many of the peripheral states alongside the ECB’s more hawkish stance means that, over the long term, the Euro will have a hard time maintaining competitiveness. As such, the political foundations, especially in the peripheral states, could gradually drift towards a Eurozone breakup as all other options will seem too difficult to swallow.