Backdoor QE, Fractional Reserve Banking, & Insolvency

It appears that market observers are only very slowly coming around to grasping the fact that what the ECB has done in December does indeed amount to a major dose of monetary pumping. The misunderstandings center mainly on the use of the ECB’s deposit facility by banks, which overshadows the far more legitimate debate over whether the commercial banks are going to use ECB funding to play the sovereign debt carry trade or rather ‘play it safe’ in view of the large amount of bank bonds maturing in the first quarter.

Now, to the latter point let us say this: there is now some evidence that they indeed do play the carry trade, by ‘riding the yield curve’ in e.g. Italian bonds. The proof is in the pudding: the Italian yield curve has gone from a slight inversion to quite a bit of steepness. The recent move has in fact been enormous. Italy’s 2 year note yield has plunged from about 7.60% in late November – at which point the spread between the 10 and 2 year note yields was inverted by nearly 60 basis points – to 4.67% today. That’s a move of approximately 300 basis points in a mere six weeks. As we have remarked previously: someone has been buying, and it sure wasn’t Santa Claus.

Click here for larger image

Italy’s 2 year note yield has plunged by 300 basis points since late November – click chart for better resolution.

Slowly but surely a few mainstream publications are catching on to the phenomenon as well. The Wall Street Journal for instance noted yesterday (finally): ‘Evidence the ECB Could Be Running Backdoor QE After All’.

Well, duh. Pumping nearly €500 billion into the banking system in a single day means the money is going to go somewhere. Since the private sector’s credit demand in euro-land is negligible and riding the curve promises to be highly lucrative, it isn’t too difficult to guess where it will go – especially  in view of the fact that governments and banks are becoming ever more intertwined via debt guarantees and capital raisings, even in nominally bankrupt Greece (as we reported yesterday).

It should be obvious that governments won’t just support their banks without getting a little something in return.

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