4/9/2014: ECB: Little Done. Loads More to Be Done Still...

In its latest move in attempting to combat the risk of deflation in the euro area, the ECB pushed the policy interest rate down to 0.05% from 0.15%. Here are some historical dynamics of the rates and comparative analysis of the ECB policy relative to other Central Banks:

Let's start from the historical chart:

The chart is showing the historical evolution of the rates in six advanced economies. At this stage, we have a statistical convergence between the US, Japanese and Euro area rates at the lower margin feasible.

It is worth noting that from January 1999 through September 2008, pre-crisis average for the Euro rates is 3.10 which is now 3.05 percentage points above the current rate. In the case of the US, current rates are 3.37 percentage points below the pre-crisis average. In the UK, historical pre-crisis average is 4.83% which means we are at 4.33 percentage points below the historical average.

The dynamics of deviations in the ECB rates from their historical average are shown below:

Statistically, mean reversion in rates is now well-overdue and accounting for likely overshooting we are looking at the mean reversion taking the rates above 3.25-3.5%. Total duration of periods of deviation from the mean in the last episodes (for rates both above and below the mean) is 85 months over 9 years and 11 months. Current deviation is already 70 months long and counting. Excluding the 1999 period, which is consistent with the period of early establishment of the euro policy, total length of combined deviations from the historical average is 78 months, just 8 months short of the current period duration.

The higher the hill in the above chart gets, and the deeper the blue line goes, the greater pain will be required to revert the rates to their historical mean. This pain is coming, whether we like it or not and its timing and extent will have nothing to do with the legacy debts in Ireland or with our capacity to service them. It will come on foot of the Big 4 euro states data.

Meanwhile, this will do preciously nothing for the euro area economy. Why? Because the problem in the euro area economy is not the rates on loans to banks or between banks, as illustrated by the chart below. The problem is that policy rates are not feeding through to the retail rates charged on real loans for real companies and households in the real economy:

As the above chart clearly shows, the banking rates track reasonably well the policy rate (blue line, showing 12 months euribor rate deviation from the ECB repo rate), but the real rates (retail rates charged on loans in excess of EUR1 million with 1-5 years maturity for euro area non-financial companies) are getting increasingly more expensive compared to the ECB repo rates (red line).

The latest cut in rates is not going to do anything to the above story. And the ECB, so far, has found no means for breaking the financial markets blockage that prevents the policy rate to feed through to the retail rates. Nor, incidentally, has the ECB discovered any means so far to break the cycle of fragmentation in the credit system - the situation where by credit rates for non-financial companies and households diverge between different countries of the euro area.

Two real and actual problems: not cured. One imaginary problem - of official policy not being absurdly accommodative enough - is now addressed. Little done. Loads to be done still... and the future interest rates hikes super gun is loaded, primed and the fuse lit already...

22/1/2012: An update to Euribor risk premium post

On the foot of the previous post, I recomputed risk premia for 3 maturities: 12, 9 and 6 months euribor. Here's the chart:

And some top of the line numbers:

To compare against rates dynamics:

22/1/2012: What do interbank lending rates tell us about risk valuations?

Here is an interesting set of charts for euribor:

Notice that as maturity span shortens, there is an increasingly rapid decline in the rates in recent month. This, of course, is a reflection of two forces acting simultaneously - the ECB LTRO and the rate drop in December. You can see this here in the context of 12 months euribor plot for end-of-month (and end of last week for January 2012):

Sounds good? Indeed, the short-term end of liquidity curve improved dramatically, but... here's a trick - the long-term end of the curve is not improving as much as (1) the repo rate supports, and (2) LTRO (3 year facility) should lead it to. To see this - here's a chart:

And the above term premium is rising despite the risk premium falling:

Note: the last chart above is not seasonally adjusted and, with exception for 2010, euribor rates tend to fall seasonally in January compared to December.

In fact, current risk premia are well above the long-term relations and at more extreme end of the spectrum than during the previous months:

The above suggests to me that what we are observing in the liquidity markets is a combination of some improvement due to ECB's LTRO move (substitution along maturity curve) and the (very) incomplete pass through of ECB rate change to funding markets. There appears to be no evidence in risk reduction anywhere in sight.

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?

Economics 28/06/2010: G20 to euribor: beware of the central banks

Update: with a slight delay on this blog's timing - Reuters picks up the same thread here.


Another Monday, another set of pear shape stats.

First, we had a farcical conclusion to a farcical meeting of G20. If Pittsburgh summit was a hog wash of disagreements, Toronto summit had a consensus view delivered to us, mere mortals who will pay for G20 policies. This consensus was: G20 leaders called for

• austerity, but not too much (not enough to derail growth, but enough to correct for vast deficits - an impossible task, assuming that public deficit financing has much of stimulating effect in the first place);
• generating economic growth (with no specifics as to how this feat might be achieved);
  
• increased tax intake (to help correct for deficits); and
• no changes to be made to the global trade and savings imbalances.

In other words, G20 decided that it is time to have a 4 course meal without paying for one.

Then , on the heels of these utterly incredible (if not outright incompetent) pronouncements by G20, Bank for International Settlements (BIS) came in with a stern warning to the Governments worldwide to cut their budget deficits "decisively", while raising interest rates. Funny thing, BIS didn't really see any irony in cutting deficits, while raising the overall interest bill on public debt. Talking of Aesopian economics - let's pull the cart North and South, in a hope it might travel West.

In many ways, BIS got a point: “...delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress” said BIS general manager Jaime Caruana. Extremely low real interest rates distort investment decisions. They postpone the recognition of losses by the banks, increase risk-taking in the search for (usually fixed) yield, perpetuating nearly economically reckless financing of sovereigns that cannot get their own finances in order, and encourage excessive levels of borrowing by the banks.

Continued water boarding of the western economies with cheap cash through Quantitative Easing operations by the CBs risks creation of zombie banks and companies with sole purpose in life to suck in liquidity from the markets. Alas, the problem is - shut these zombies down and you have no means for monetizing public debt in many countries, especially in the Eurozone. Boom! Like the main protagonists in Stephen King's movies, governments around the world now need zombies to rush into their disorganized homes before the whole plot of deficit financing blows up in their face.

BIS also warned that many economic experts and central banks are underestimating inflation risks. And this is just fine, assuming you are dealing with short term investment horizons. However, for a Central Bank to ignore the possibility of a restart of global inflation - fueled by the emerging markets growth and later also supported by accelerated inflationary pressures in the advanced economies following the re-flow of liquidity out of the bank vaults into the real economy once writedowns are recognized and banks balancesheets stabilise - is a very dangerous game. inflation, you see, is sticky.

And inflation might be coming. Look no further than the Fed (here) and the US Administration insistence on the need for continued debt-financed stimulus.

Or, look no further than the movements in the interbank lending markets:

So the long term Euribor is up, up and away despite all the Euro area leaders' talk about fiscal solidarity funds and tough austerity measures. Think: why? Either the interbank markets don't believe in Euro area's ability to get its own house in order (which they certainly don't) or they believe that future inflation will be higher (which of course they do)...

Hence, shorter maturities are in an even more pronounced push up:

While dynamically, the trends are deteriorating:
Now, think about the Irish banks (Spanish, Portuguese, Greek - etc) that are on life support of interbank markets and ECB. Can they sustain these credit prices?.. While facing continued writedowns?.. Don't tell I did warn you about these.