Trillion euro bet by ECB

In this article Will Bancroft looks at the continuation of the ECB’s lending facility, what its impact will be in the markets, and whether the ECB is aware of the risks of its policies. The analysis looks at a rose tinted future the ECB is banking on, how the people of Southern Europe can check mate the ECB if they do not play ball. Read on for more and what this all means for the gold price.

The European Central Bank has morphed into quite a different animal under the leadership of Mario Draghi. We have looked at Mr Draghi’s Long-Term Refinancing Operation (LTRO) before, although this was merely the first round. The LTRO has largely helped sate the Eurozone’s liquidity crisis, although the greater problem of solvency is more difficult to cure. Today we found out what the take up of LTRO mark II was: 529.5bn euros across 800 banks.

LTRO generally has had its desired effect and was a masterful act by the Draghi ECB. Although we disagree with such activity by central banks, LTRO has successfully kicked the can down the road for perhaps three years and delayed a Lehman style event at least for a while. It is a clever way of plastering over structural flaws. LTRO is an ingeniously indirect enough measure to avoid being labelled as pure quantitative easing, but the ECB is essentially acting as the lender of last resort to European governments. Stealth easing if you like.

The European banks, especially Italian and Spanish ones, have increased their holdings of domestic government debt. Spanish and Italian bond yields have declined significantly. LTRO had given birth to a state sponsored carry trade, where banks would borrow from the ECB at 1 per cent for year years and earn 5 per cent on Italian or Spanish 3 year paper, for example. This carry trade proved so lucrative that significant purchasing power has seen yields come in most at the 3 years and less duration. LTRO is widely being termed a ‘sugar rush’ for the markets, and it is just that. But, we know what happens after a sugar rush in economic and physiological terms.

The ECB is hoping that by the time its LTRO operations expire years down the road, the indebted Southern European nations will have reformed their economies, will be growing once again, and their bond markets will be enjoying healthier demand. They want to grease the path to this potentially healthier economic future.

The ECB’s gamble

The problem for the ECB is that it is betting on a future that the collective wisdom of the market deems unlikely to happen. This is why private investors had grown less and less willing to finance the PIIGS. The economic and policy reforms needed to get the south of the Eurozone economically healthy again are likely to take years to raise growth rates. During this time debt levels will remain concerningly high and stresses in the Eurozone will remain.

There is so much that is out of the control of the ECB and private investors. If Eurozone governments fail to generate growth and put in place adequate firewalls, the ECB’s gamble might return to haunt it. The Troika can seek to coerce governments and even insert technocrat leaders all they want. If the populations of the indebted nations don’t believe in the bail outs and their terms, the ECB and Troika have been checkmated.

The whole euro strategy depends on countries like Italy, Spain and Portugal (we ignore Greece as irrecoverable) implementing labour market reform, becoming more competitive, paying down their debt, and generally growing as economies again. But the citizens of these nations cannot be forced to work harder, find new jobs (after their bloated public sectors are slimmed) and start businesses if they don’t believe in the EU or its strategy.

Greece is an example for the ECB

The situation in Greece is a worrying example of what sort of dynamic might unfold.  The battle for hearts and minds in Greece has been lost, and shows little signs of being won.

Civil disobedience is now rife in Greece. On the 12^th of February, when the Greek parliament met to decide on whether to accept the new bailout package, there were 80,000 odd people demonstrating on the streets of Athens. Many of these protestors attempted to storm parliament. 10 major buildings were set ablaze and the 5,000 police had to use tear gas to disperse the crowds. The Greek people don’t see themselves as the beneficiaries of the bailouts. They see it as a bailout of foreign banks. There is now nearly 50 per cent unemployment amongst young people in Greece, and 25 per cent of all commercial companies have gone bankrupt in Greece in the last four years.

The Greek Prime Minister offered a deeply ironic quote in his subsequent speech: ‘Violence and destruction have no place in a democratic country.’ What democratic country? Democracy was born in Greece, but the current technocracy cannot claim a democratic mandate.

Greek economic contraction is not slowing if anything it is accelerating. Furthermore the Greek authorities are also crucially losing their abilities to control the situation as members of the police and fire services increasingly question their political orders and sympathise with the protestors.

The way the Troika is losing the battle for Greece appears instructive.

LTRO and the gold price

As we have looked at elsewhere, the gold and silver prices have shot out of the blocks so far this year. But, what will the ECB’s continued liquidity provision mean for the gold price?

We looked last year at how a rush for liquidity in the markets had weighed on the gold price, but the ECB’s continued provision of sweets and sugar to investors and the current positive liquidity environment would appear supportive of the gold price. No doubt this would be welcomed by precious metal investors after chops in gold and silver last year.

A few notable gold investors have begun to call a short term bull trend in gold, predicting highs of $2100/ounce by May. We are loath to forecast gold and silver prices in the short term, but the rise is the gold price achieved this year occurred against low sentiment levels whilst positioning was still light. Within this there was still significant enthusiasm for the short side in a market that appeared structurally oversold. There also appears to be central bank buying activity returning to the market again since the 20^th of February. Central bank flows into the physical may have caught some of the short activity offside.

We will have to await the market’s reaction and digestion of LTRO II, but the ECB is doubling up its bet and a new level to the house of cards has been built. Will LTRO buy enough time for Italy, Spain and Portugal? We find it difficult not to answer pessimistically. The costs to the ECB, and thus European tax payer, look set to deepen and continue.