Gift Wrapped Liquidity
Is the ECB about to give Europe's governments and banks the biggest Christmas present of their lives...?
With Christmas a little over three weeks away, the European Central Bank may be about to hand indebted European governments - not to mention its banking sector - the biggest gift they ever received: an unlimited credit backstop.
It is now being widely reported that there 'only ten days left to save the Euro'. Even Metro - the free newspaper found discarded by commuters on British trains and buses each morning - made it their front page splash today.
The FT's Wolfgang Munchau was pushing this meme earlier in the week - but it was European commissioner for economic and monetary affairs Olli Rehn that really got it going with these comments yesterday:
"We are now entering the critical period of ten days to complete and conclude the crisis response of the European Union...There is no one single silver bullet that will get us out of this crisis."
The ten day dead deadline refers to the European leaders' summit at the end of next week. Is such a deadline justifiable? Will the Eurozone begin to disintegrate if no convincing solution comes out of that summit?
Quite possibly. Predictions of Eurozone demise within the fortnight could turn out to be self-fulfilling. An ultimatum has been laid down - if politicians appear to have ignored it, it could be fatal for what little confidence investors have left in Europe.
All of which could go some way towards explaining yesterday's coordinated central bank action. The headline move was the lowering by 50 basis points (half a percentage point) of the cost of borrowing US Dollars. This makes sense given the speed at which international capital is fleeing Europe, as investors head for the perceived safety of the world's sole reserve currency.
The coordinated central bank statements, though, seem to be preparing the ground for something else too. The following paragraph was common to all six of the central banks involved in the action (The Federal Reserve, the ECB, the Bank of England, the Bank of Japan, the Bank of Canada and the Swiss National Bank):
'As a contingency measure, these central banks have also agreed to establish temporary bilateral liquidity swap arrangements so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant. At present, there is no need to offer liquidity in non-domestic currencies other than the US Dollar, but the central banks judge it prudent to make the necessary arrangements so that liquidity support operations could be put into place quickly should the need arise. The swap lines are available until 1 February 2013.'
In other words, central banks are preparing to step up their provision of currencies other than the Dollar. This could be a sign that the ECB is about to take a more active role in the Eurozone crisis.
Indeed, each central bank's statement had a version of the following, taken from the ECB, dealing with its own particular currency:
'The Governing Council of the European Central Bank (ECB) decided in co-operation with other central banks the establishment of a temporary network of reciprocal swap lines. This action will enable the Eurosystem to provide Euro to those central banks when required, as well as enabling the Eurosystem to provide liquidity operations, should they be needed, in Japanese Yen, Sterling, Swiss Francs and Canadian Dollars (in addition to the existing operations in US Dollars).'
Here's a rough outline of where we stand in this crisis:
Investors are wary of Eurozone government bonds. This reluctance to lend to governments has pushed borrowing costs to unsustainable levels in Italy and Spain. France may be next.
It is hoped that the Eurozone's rescue fund, the European Financial Stability Facility, will be able to solve this problem by ensuring there is sufficient demand at government bond auctions to bring yields back to sustainable levels - for example by offering partial guarantees on losses. However, the EFSF lacks the necessary funds to do this for larger countries, and is having trouble raising cash itself.
French finance minister Francois Baroin has called repeatedly for the EFSF to be given a banking license so it can borrow from the ECB (Germany is dead against this). And here's what Bank of France governor and ECB Governing Council member Christian Noyer said yesterday: "In a period of intense market disruption, it is essential to ensure that the monetary policy transmission mechanism actually works. This may involve temporary and exceptional interventions on those market segments where dysfunctions are most apparent."
European leaders now have a de facto ultimatum: sort this out by the end of next week, or else.
There is an ongoing push, led by Germany, for a 'fiscal union' - involving greater oversight of national budgets and the like. But fiscal integration is preventative measure - not a solution to a crisis that has already erupted.
Markets are looking for a solution this side of Christmas. The only agent in a position to act that quickly is the ECB.
ECB president Mario Draghi spoke to the European Parliament this morning. While he gave his support to what he called "a new fiscal compact", he did make some comments that may hint at further ECB action over and above its ongoing bond purchase program (which clearly isn't working, as Italian and Spanish bond yields attest).
"As you know, the ECB's monetary policy is constantly guided by the goal of maintaining price stability in the Euro area over the medium term," said Draghi.
"And when I say this, I mean price stability in either direction. This applies to both the setting of official interest rates and the implementation of non-standard measures." (emphasis ours).
There was also this potential hint:
"I am confident the new surveillance framework will restore confidence over time. I am also quite sure that countries overall are on the right track. But a credible signal is needed to give ultimate assurance over the short term." (emphasis again ours)
Might that "credible signal" be an offer to provide whatever liquidity is needed to assuage fears in key markets?
There are several mechanisms, for example, by which the ECB might seek to prop up government bond prices (and thus keep yields down). It could find a way, as touched on above, to get more Euros into the hands of the EFSF. It could buy the bonds directly at auction (unlikely, and currently forbidden by several European treaties, but at this stage of the crisis little can be ruled out...). Or perhaps some other method would be found.
The net aim is the same whatever the mechanism: to get Euros to governments who need to roll over their Euro-denominated debt. If there are insufficient investors willing to hand over their Euros, logic suggests that one solution is to turn to the ECB, from whence Euros originate. The ECB, after all, has access to an unlimited number of Euros.
There are also fears over the banking sector, which yesterday suffered a swathe of downgrades from Standard & Poor's (which in turn may have precipitated the central banks' announcement). Lower ratings could seriously impair some banks' ability to borrow in the money markets - which is also a reason we see the world's lenders of last resort priming their pumps.
In short, get ready for a world of uncapped credit availability, as the authorities step up their fight against deleveraging - like the cavalry in a Western, riding over the hill when all hope seems lost. Saddle up, Draghi!
Long term, a liquidity boost would tend towards a higher gold price, other things equal. However, there could be significant downside risk for gold, with or without a solution being announced at next week's summit. If markets are unconvinced, we could see the sort of mass liquidation that has been common in recent weeks - and that has hit gold and silver along with stock markets.
If, on the other hand, the markets buy whatever the Euro leaders are cooking, then we could see some weakening of safe haven demand for gold, at least in the immediate term.
Either way, though, Europe will still be in a mess. Growth is sluggish (today's Eurozone purchasing manager's index shows a manufacturing sector shrinking at an accelerating rate).
Outstanding debts, therefore, will either be dealt with via default, or they will have their real value diminished - which means reducing the value of money itself. Default or devalue remain the watchwords for creditors.
So while the ECB may be convinced that it has 'ten days to save the Euro', if it ramps up its liquidity provision it could end up doing the exact opposite.