The provision of effectively unlimited loans to eurozone banks at a rate of 1% for 3 years, from electronically created – or ‘printed’ – money, was unprecedented in the scale and length of the stimulus provided to the European banking system.
It took time for the full impact of this to be recognised by equity markets, although by the time the second round of the programme came, its scale was a keen focus for all markets. However, the impact in terms of confidence within the banking system and the effect of bond yields in the periphery of the eurozone was rapid, and it transformed the appetite for risk in most markets for many weeks.
Almost all the world’s leading equity markets rallied by at least 8% in January and February; and bond yields in Spain and Italy, which were something of a fixation for markets last autumn, fell back to comfortable levels.
Effect on asset classes
Apart from the most immediately headline-grabbing impacts on European bonds and equities, the programme was felt across many other asset classes. It seems to have been a tangible factor in the depreciation of the euro against most currencies this year, and it probably fed through into commodity prices as well. It gave a fillip to all the world’s markets, but it particularly helped financial shares and depressed cyclical stocks, such as house builders, which are deemed particularly to benefit from the easier availability of credit.
However after nearly six months of the programme, it is not likely that there will be a third round, despite recent market volatility. It seems timely to ask if there are any ongoing ramifications of the LTRO for investment strategy, and if so what are they? To do this, it is helpful to think first about what the LTRO was – and was not – and what it was trying to achieve.
Unlike Quantitative Easing (QE), which would have involved the ECB printing money to buy assets, the LTRO purpose’s was to lend a large amount of money to banks with a cash flow problem, preventing them from getting into serious difficulty. But the process meant that to access the cheap money from the ECB the banks had to deposit assets, often Government bonds, with the ECB. Rather like a mortgage, these bonds would become the property of the ECB in the event of default.
Even so, it expanded the money supply and greatly improved banks’ confidence in the solvency of the other institutions with which they trade. Capital has therefore been moving more freely around the system. This has given a modest stimulus to bank lending, and also encouraged a ‘carry trade’ in which banks have used the cheap loans to buy sovereign bonds and other assets that offer more generous yields.
Short-lived boon?
Nevertheless, the impact is likely to be essentially transient. Confidence in the banking system is likely to remain a little healthier than it was, despite renewed concern about Greek default. However, while the process avoided a crisis, it has not translated into a major increase in loans to businesses and consumers, which is a prerequisite for a sustainable economic improvement. The LTRO gave a boon to the liquidity, but not the solvency, of Europe’s financial system. When the loans expire the cost of borrowing will presumably rise again, and the deleveraging process could have a depressing effect.
The experience of QE, especially in the US, was that the benefit to markets tends to wear off quite quickly when the programme ends, and most investors assume that the same will prove the case with the LTRO. Already bond yields in peripheral Europe have become more volatile, and equity markets have found the going harder since mid-March.
While we don’t underestimate the benefit to the economy of improved confidence, we think that investors would be wise not to expect markets to enjoy nearly as much benefit in the remainder of the of the year as they did in the first quarter from the actions of European policy-makers.
