Target2: The New QE .... and QT

by Michael J. Howell4. April 2013 11:24


To solve US funding problems, the Fed has willingly and unambiguously taken the dysfunctional US wholesale money markets and essentially put them on to its balance sheet. The ECB has indirectly, unconsciously and, possibly, unwillingly done the same through the Target2 system. The Target2 balances measure the cumulative balance of payments disequilibria between Eurozone economies. More accurately they underpin these disequilibria because Target2 is an automatic lending system that prevents the need for the deficit economies to adjust.


This was not, of course, how the system was designed. No one truly foresaw that the wholesale funding markets could disappear for so long and that the ECB would be compelled to finance these funding needs for years. Consider an example. Say, a Spanish bank loses deposits for whatever reason to a German bank – capital flight or trade. Normally, the Spanish bank would either correspondingly reduce its loan book (and investments) or replenish the funding by borrowing indirectly from the German bank through the wholesale money market. Credit concerns now rule this out, so instead the Spanish bank effectively borrows from the ECB (via the Bank of Spain). The German Bank can now choose either to increase its overall lending; increase its reserve balance at the ECB or reduce any borrowings it has from the ECB. The actions of Spain keep the Spanish component of the Eurozone monetary base intact; the actions of Germany will increase the German monetary base if German banks build up their reserves, or leave it unchanged, if the banks pay off ECB loans. Commercial forces likely push the German bank to maintain its funding and build up reserves, thus increasing the German component of the Eurozone monetary base.  Adding these bits up, the total Eurozone monetary base should rise and fall pari passu with the Target2 balances.

The actual data tell a staggering story: over the period since the Euro started in 1999, the correlation between the Eurozone monetary base and the size of German Target2 balances (both measured in Euros) is 0.027; from 2009 this jumps to 0.511; from 2010 to 0.623 and since 2011 to 0.787. From 2012 onwards, it hits a whopping 0.954, showing that the two series move virtually step-for-step. They are indistinguishable. Therefore, the latest fall in Target2 and the associated drop in the Eurozone monetary base shows a inadvertent tightening of monetary conditions. We have been warned.

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Cyprus: illiquidity vs insolvency

by Michael J. Howell30. March 2013 11:34
Banks are often insolvent: they are less often illiquid. Insolvent banks can survive: illiquid ones cannot. The key Cyprus banks and probably many Spanish banks are insolvent, but only the Cyprus banks are currently illiquid. The gift of more liquidity from the IMF/ ECB has been made conditional on depositors suffering a 'haircut' on their deposits. Many think this unfair, but is it? Cyprus banks allegedly lost most by investing in Greek debt. Unlike most other Western banks they were predominantly funded by retail deposits rather than wholesale funds. In other words, Cyprus is more an old-fashioned case of poor lending/ investment decisions than a question about lack of wholesale funding. Moreover, it is not systemic, or too big to fail. It is Europe's equivalent of the Barings failure.Therefore, the IMF/ ECB can afford to take a tough line. On the other hand, it is a fine-line being drawn here, and one that sees to rest on the source of bank funding. Spanish banks have also made poor lending decisions, but they are bigger, lately more dependent on wholesale funding and, more importantly, more likely a systemic threat. The ECB is funding these and other banks either directly through its balance sheet or indirectly through the Target2 balances. Therefore, strictly in pure banking terms the ECB are probably correct to force a haircut on Cyprus although the size is up for debate. What is less clear is why they are not doing the same for other Eurozone banks and, moreover, why the funding playing field is so uneven and ill-thought out. It tells us that (surprise, surprise) all decisions are political, and they are reactive. The air of crisis management hangs like a pall over the Eurozone. We remain skeptics, not about the integrity of the Euro, but about it's level. Future funding crises seem inevitable, and hence the Euro must drop more.

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More Euro Mess

by Michael J. Howell27. March 2013 11:44

We cannot see how the Cyprus news is good, particularly when viewed in context. The ECBs balance sheet has shrunk by nearly 20% over the past six months, thereby depleting overall funding. We acknowledge that this funding may not be needed right now, but that is only (a) because funding markets have not been tested lately, and (b) banks do not want reserves because they too are contracting their balance sheets as lending falls away. This is not good news. It may also reflect the huge skew in Eurozone funding conditions. The still whopping Target2 balances tell us that 'Northern' banks have surplus funds and so can afford to payback long-term loans to the ECB. Yet they do not tell us that the 'Southern' banks are off the ECB drip-feed. Consequently, even a reduction in Target2 balances are not a sufficient condition for the Euro Crisis to end. Troubles likely lie ahead given the skidding levels of our Eurozone liquidity indexes. We have been warned.

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Poor News....Capital Flows to EM

by Michael J. Howell27. March 2013 11:36

Latest End-February data on net capital flows to EM do not make great reading. The late-2012 rally in net inward funds has died out. Both Jan and Feb saw net out flows totalling US$0.5 trillion at an annualised rate. Excluding the BRICs, other EM managed a small US$0.1 trillion annualised net inflow. China looks bad. We have had 10 of the last 12 months showing large net outflows. The only brigt spots are India where inflows continue strongly, Indonesia, Czech, Poland, South Africa and Turkey. Capital inflows are important for monetary conditions since they often lead EM Central Bank policy actions. As we have warned, the strong US dollar is starting to weigh heavily.

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GLI February 2013 Data Release

by Michael J. Howell13. March 2013 21:48
February 2013 data released today show our headline Global Liquidity Index (GLI) hit an index of 62.1, 'normal' range 0-100. This is up from the 58.1 January 2013 reading and is the highest value of the index for more than a year. Contact us for more information.

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CBC Financial Stress Index, w/e 8/3/2013

by Michael J. Howell12. March 2013 14:18

Our Financial Stress Index fell to 75.7 at w/e 8/3/2013, or the lowest stress reading since July 2011. This index comprises several measures of US credit market tensions and correlates closely with the St Louis Federal Reserve's own Financial Stress Index. Our index is set at a base level of 100 for Year 2000. The index hit a peak of 339.9 at w/e 17/10/2008 and a low of 56.0 on 4/3/2004. 




Bank of England Liquidity Injections...More QE Needed?

by Michael J. Howell12. March 2013 12:51

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What Do Central Banks Do?

by Michael J. Howell11. March 2013 12:11

Prompted by yet another claim, this time by the great house of Goldman that Central Bank QE push up bond prices and push down yields by circa 100-125bp, it is worth looking at the facts and the theory. QE1, QE2 and now QE3 have seen generic 10 year yields rise. The ending of QE1 and QE2 saw 10 year yields fall. It is really that simple. If the 10 year bond represents the risk free asset for many long-term funds, then Central Bank balance sheet expansion will likely lower the risk premia on other risky assets and raise the risk premia on bonds. In short, the yield curve will steepen after each QE: it did and it is again now. Why the fuss? Surely, this is exactly what policy-makers want to do? Falling long-term yields would signal their failure not their success!

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A Peak With A View?

by Michael J. Howell10. March 2013 22:02
New highs on Wall Street have prompted inevitable navel-gazing. A popular repost is the 'lack of correlation between GDP and stock prices'. Another is the artificial '100-150bp drop in bond yields caused by QE policies'. The real questions should be (1) is there a strong correlation between GDP and profits growth, and (2) what governs the valuation of these profits? The first answer is an unequivocal 'yes' and the second comes down to two things - the scale of QE (and other liquidity effects) and the underlying inflation rate. It is clear that more QE reduces risk premia on risk assets. Since bonds are a low risk asset for long-term funds, QE is more likely to raise not lower risk prema on bonds. Therefore, the longer than QE persists, the more that equity risk premia will fall and bond risk premia will rise. Regarding inflation, Central Banks do not create CPI inflation, but governments do. While private sectr debt is high and excess capacity high, there will be no acceleration in inflation. Therefore, based on these 'internal' risk factors, Wall Street et al should rise. But two 'external' risk factors worry us: a too strong US dollar and the recent tightening by the ECB. End-February GLI liquidity data will be published around March 14th. They need to be watched.

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New Report 'Dance of the Dollar'

by Michael J. Howell7. March 2013 17:11

Research published today analyses swings in fortunes of US dollar and how its gyrations affect the global investment cycle

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