24 Dec 2011

QE to infinity and beyond

At JSMineset.com, one commentator offers a pithy summary of this week’s long-term refinancing operation (LTRO) measures from the European Central Bank:

“Today the ECB provided a nearly half trillion euro loan to European banks.

More than 500 European banks took this 3 year loan at 1% interest.

The ECB plans to do another 3 year loan offer early next year (maybe February).

In exchange, banks are supposed to buy Sovereign Debt from European countries. Banks can pocket the huge differential in interest! What a Christmas present!

Jim, you said it first. Western governments are into QE to infinity!”

Given European banks deleveraging needs, however, sovereign bonds may not receive the bids that some had hoped. Reuters notes that bank analysts expect no more than €100 billion of these loans to be used to purchase more sovereign debt from the likes of Italy and Spain. Morgan Stanley estimates some €20-50 billion euros of Italian bonds could be bought. To put this in context, Italy must refinance about €150 billion of government debt from February-April alone. Likewise, French banks are expected to use the new loans to increase private sector lending and slow their deleveraging, rather than as a means of buying more sovereign debt.

So while this record liquidity injection may go a long way in terms of easing conditions in the European banking sector, the continent’s sovereign debt difficulties remain another matter. And while the next tranche of ECB bank loans scheduled for early next year will be just as heavily subscribed as this week’s was (who can say no to such cheap money?) as Reuters comments, the risk is that banks are becoming ever-more reliant on the central bank. This sentiment was echoed by Bank of England Governor Mervyn King, who remarked yesterday following a meeting of the European Systemic Risk Board in Berlin that “dependence on central banks has risen and signs are intensifying that stressed financial conditions are passing through to the real economy.”

In truth, markets are totally reliant on central banks. They have arguably been so for at least the last decade – following the decision from Alan Greenspan's Fed to target sub-2% interest rates as a response to the bursting of the Nasdaq bubble in 2000 and the US recession of 2001-2002. But in their endless “war” against deflationary threats and the dreaded spectre of “internal devaluation”, (a war in which savers necessarily become collateral damage) central banks face the need for constant escalation of policy responses.

This is in order to prevent accumulated malinvestments fostered by earlier rounds of easy money from collapsing. Each new round of monetary easing results in a greater total of misallocated capital, which makes going “cold turkey” that much more difficult for the economy. This means that if a deflationary collapse is to be delayed, the next intervention from the central bank must be even more aggressive than its previous intervention.

So what was regarded as loose monetary policy a decade ago becomes merely standard procedure today. This can be seen in the way in which zero-per cent interest rates have now become seemingly a semi-permanent part of central bank policy in developed nations, with the Fed promising to keep rates pinned to the floor until at least mid-2013.

Where does this end? Further purchases of dubious mortgages, nominal GDP targeting, purchases of stocks – perhaps even the targeting of specific levels on popular stock indexes. None can be ruled out as weapons that central banks might deploy in the coming years in order to support the existing (tottering) financial edifice.

Given the market’s sensitivity to central bank policies, it’s ironic that its missed perhaps the most significant central bank act of the last year: amid all the talk of how the ECB “isn’t doing enough” to “support” the eurozone (read: isn’t printing enough money), as ZeroHedge notes, the ECB has printed €500bn in the last six months – more than the Fed did in all of QE2.

Despite this largesse, gold and silver prices have been correcting since early September – which just goes to show that as far as the markets are concerned, perception matters just as much as reality. In this case, the perception that a “hawkish” ECB was prepared to countenance deflation and banking collapses in the eurozone, and that this was bearish for gold and silver prices.

In the words of ZeroHedge:

“Ironically, the broader "risk on" crew has not missed this, and while gold continues to be stuck in the old paradigm, it refuses to comprehend that explicit guarantees of trillions in debt (such as the LTRO repo operations), is an equivalent operation to printing money.

We fully expect the correlation arbs, which usually need someone to point out the glaringly obvious to them before they encode given relationships and correlation pairs into buy and sell signals, will very soon comprehend why the one most underpriced asset at this point, by orders of magnitude, is gold.”

And on that note, we at GoldMoney would like to wish you all a very Merry Christmas.