Yesterday we saw an example of a new factor in the Euro zone crisis that I discussed back on the 2nd of December. Although to be fair it is better to say that it is a new variant of a factor which has been at play in the past. Below is a link to that article
So as you have probably gathered I think we saw a clear example of this sort of “round tripping” tripping yesterday and it took place at the Spanish government bond auctions.
Spain sold a combined 6.03 billion Euros of government bonds with maturities of January 2016, April 2020 and April 2021. Now in the current nervous environment that may seem something of an achievement in itself but it seems even more remarkable when their target was to sell only 3.5 billion Euros!
What created this sudden enthusiasm for Spanish government bonds?
The examples I gave on the second of December have something else to support them now and it is due to a new initiative at the European Central Bank. It announced at its last policy meeting that it will hold two separate three-year long-term refinancing operations and the first of these is on Tuesday.
So as long as you have collateral (Spanish government bonds are collateral) you can have as much money/liquidity at an interest-rate of 1% as you want for three years. So the 2016 bonds which were issued yesterday at a yield of 4.02% suddenly look attractive do they not. You can finance them for 1% for the first three years of their life and make just under 3% a year (there will be a “haircut” applied by the ECB).
Also existing bonds look attractive and if we look at the yield on existing 3 year maturity Spanish bonds they have fallen from 5.1% on the day of the ECB announcement to 3.57% as I type this. Suddenly the improvement in the price of these bonds does not look as good as it did before did it? Yet again risk is being moved around but the underlying issue is unchanged and taxpayers find themselves potentially on the hook yet again should this pack of cards fall down.
How might this go wrong?
If we look at the case of Greece this type of trade went on around a couple of years ago but as her situation worsened her government bond prices fell heavily and a typical price is now 20 compared with a par value of 100. In essence the danger is capital losses that may be greater than the carry or interest-rate profit. In the case of Greece they turned out to be much greater nad had led to her banks becoming zombie banks.
Does this tell us who might be doing this?
It gives us some clues. For example if you are a Spanish bank then heavy falls in Spanish government bonds might make you insolvent anyway so they might think why not have another go? After all if it works they will no doubt tell us how clever they are and award bonuses all round! So there are elements of a one-way bet here. We are back yet again to moral hazard and asymettry.
Foreign banks may also be willing to do this and ironically it may be the weaker ones who are most likely to do it on the same logic as explained above.
Never believe anything until it is officially denied
The words of Sir Humprey Appleby the apochryphal civil servant of Yes Minister fame came to mind as I read various reports yesterday that this was not really happening.
Other Countries are showing the same trend
If we look at the case of Italy her three-year bond yield has dropped from 6.6% on the day of the LTRO announcement to 5.5% as I type this. In Belgium we have seen a drop from 3.88% TO 3.05% too.
Will this affect other maturities as well?
Whilst there is not a pure arbitrage here I am sure that some will be tempted by the potentially higher returns that are on offer. For example Spanish ten-year bonds yield 1.6% more than their three year counterparts.
So the recent recovery in many peripheral Euro zone government bond markets is now easier to explain and is at the price of their taxpayers who are underwriting the offer of 1% finance at the ECB.
Where does this go wrong?
In my opinion taxpayers should be underwriting productive schemes rather than bank round-tripping. If you are offering funding at 1% why not give it to businesses which produce things?
The ECB’s balance sheet gets ever worse
Here is a theme of mine and here are my thoughts from just over a year ago (6th December 2010).
the balance sheet of Europe’s central bank looks ever riskier to me and it is quite conceivable that we could be in an era where central banks as well as private-sector banks need bailing out.
If we look at progress since then it has very heavy losses on its Greek Irish and Portuguese government bond holdings and now losses on its Italian government bond holdings to add to it. So in every sense the position is now worse. It also has a 60 billion bank covered bond portfolio which as we see nearly every day signs of an increasing bank liquidit crunch in Europe we do not need to spend too much time debating its (lack of) quality.
This is before we get to the quality of the collateral it holds…..
The ECB of course denied all this back last year before making arrangements to double its capital! As to the exact mechanism well it transfers 92% of its holdings back to the constituent national central banks and so they will be left holding the parcel should the music stop. It has always struck me as a Baldrick (of Blackadder fame) type cunning plan to send such losses to the central banks of Greece Ireland and Portugal in particular.
The Bank of France attacks the UK
Monsieur Noyer the head of the Banque de France pointed this out yesterday.
UK has a bigger deficit, as much debt, more inflation, weaker growth than France
Apparently he also went on to point out that les ros bifs are perfidious, that the Duke of Wellington was lucky at Waterloo and that both Shakespeare and Dickens translate poorly into French and are not worth bothering with. Having learnt that his car is protected from lightening by a (Michael) Faraday cage he wants it removed and will take his own risk and he will never ever again use a microwave!
Ok,ok I have made the last paragraph up. But we seem to have entered a period which is exhibiting two flaws.
1. Central bankers are behaving like politicians
2. Whilst there is talk of co-operation in reality there is much discord which reminds me of the competitive devaluations of the 1920s and 30s. Unfortunately this is a dreadful analogy and we must hope that this stops.
The Office for National Statistics joins in
It may be for best that Monsieur Noyer was not aware of this when he gave his interview.
The net worth of the UK public sector, measured on a National Accounts basis, fell to approximately zero by the end of 2010, largely as a result of increased government bond liabilities
And it doesnt stop there.
Unfunded public service pension scheme obligations standing at £1,016 billion at 31 March 2010
Unfunded state pension obligations, which stood at £1,350 billion when last officially estimated at 31 March 2005
The WGA also identify a further range of more remote public sector contingent liabilities, some of which are unquantifiable. Those which were quantifiable amounted to over £600 billion at 31 March 2010.
So grim numbers but I do have a thought for you on them and it is that the numbers are based on asssumptions and estimates which are unreliable. So whilst the principle of the numbers above is true they are incredibly unlikely to be.
A new financial dictionary
I am setting out to compile one of these and would be interested in readers thoughts and ideas. For example the way the word “temporary” now covers any time period you choose between now and the end of recorded time.