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Foreign Exchange

ECB's vicious circle sows the seeds of panic

The ECB’s liquidity operations may have induced an unsustainable vicious circle among Europe’s troubled banks as eurozone contagion fears make a return to traders’ radar screens.

The ECB’s two LTRO operations provided Europe’s banking sector with more than €1 trillion in an attempt to calm burgeoning fears of a bank liquidity crisis and provide European banks with much needed cash. Consequently, Spanish and Italian banks, among others purchased more than $120 billion of their own sovereign bonds between November and February, according to recent reports. That caused perilously high sovereign yields to decline and the deluge of liquidity lifted bank bonds, while equities rallied. This was due not only to the improvement of bank balance sheets resulting from cheaper cost of capital, but also because of the significant rally in the banks’ assets – namely, their large holdings of sovereign bonds.

A seemingly virtuous circle emerged and the ECB’s actions were seen as the saviour of the Europe.

But when things are in reverse, the virtuous circle soon transforms into vicious circle, warns Marc Chandler, currency strategist at Brown Brothers Harriman.

“The ECB’s liquidity fuelled monetary policy whereby weak banks buy weak sovereign debt resembles something of a Ponzi type scheme,” says Chandler.

“It’s true that when it works out, there is a positive multiplier effect. The problem is when it does not work out.”

This problem has become apparent as the dark cloud of European contagion fears has returned in recent weeks. Spain's 10 year yield has risen about 115bp since early March, Italy's 10-year bond yield by about 100bp, and today EURUSD tested the very bottom of its recent trading range around $1.3050.

Disappointing non-farm payroll figures ahead of the four-day Easter break helped spark a risk-off tone which was felt in the currency markets, but yesterday’s sharp sell-off in European bank stocks and peripheral bonds demonstrates that the real issue is not the US, or even China.

The biggest issue is still Europe, says Benoit Anne, currency strategist at Société Générale.

“It would not take much at this point for some serious panic to settle in again in the eurozone, with severe repercussions for global markets.”

Without signs of further action from the ECB, the risk scenario we are facing could be a possible replay of the bearish spiral in the last quarter of 2011 when EURUSD reached lows around $1.26 and EMFX suffered strong sell-offs, says Anne.

However, even if the ECB did come out in force in an attempt to push bond yields lower, the reaction in markets would perhaps not be clear cut, says Simon Smith, chief economist at FXPro.

In the first instance, yields may be pushed lower, but whether such a move could be sustained is far from certain in the new circumstances.

“Far from being seen as the saviour, the ECB could be seen as the Grim Reaper, the presence of which signifies the impending demise of the countries’ solvency.”

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