The European Central Bank (ECB) under Mario Draghi has started to repair the damage done by former head Jean-Claude Trichet and some of the hawkish Bundesbank members who have since departed. The pledge of unlimited long-term repo operations (LTRO) with three-year maturities on December 8, 2011, together with the lower cost of dollar swap arrangements announced on November 30, 2011, has stanched the liquidity crisis in Europe?s banks and put an effective ceiling on funding costs for the banking system. In addition, the moves have caused a substantial drop in funding costs for at-risk sovereign debt, especially at the shorter end of the maturity spectrum (see Exhibit 1). Drops at the longer end have also occurred but are more dependent on the outlook for fiscal reforms on a country-by-country basis. Spain, in particular, has convinced the markets it is on a more sustainable course and has therefore seen a bigger impact on its long-term funding costs.
Sovereign Rates Falling Click to expand
Italy has been the biggest beneficiary of short-term rate declines, with its two-year sovereign yields dropping more than 400 basis points (bp) between November 29, 2011 and February 20, 2012. This is not surprising, since Italy has the most scope for yield compression from unlimited ECB liquidity provisions out three years. Spain and France likewise saw their two-year yields plunge by more than 280 and 50 bp, respectively. Germany, on the other hand, whose bonds are relatively safer, saw its two-year yield fall more or less in line with the ECB?s December 8, 2011 quarter-point rate cut (Exhibit 1). Ten-year yields, on the other hand, have moved less and depend more on solvency issues that reflect prospects for sustainable fiscal reform. In that regard, Italy and Spain have improved relative to Germany. Many vigilantes will remain focused on Italy as the front line of the European debt crisis.
The ECB?s New policy direction has helped reduce volatility to more normal levels.
Solid U.S. economic data and record corporate profits have not been rewarded with significantly higher prices for ?risk assets? such as stocks; instead, the risk posed by Europe?s financial crisis has kept pressure on equity risk premiums and price-to-earnings (PE) multiples. Nevertheless, the reversal of the ECB?s ill-timed rate hikes and more generous liquidity provisions have started a healing process that is evident in the collapse of volatility and rise in U.S. equity indexes. As seen in Exhibit 2, equity market volatility measured by the Chicago Board Options Exchange OEX Volatility Index (VIX) has dropped sharply since the late-summer scare when there were maximum concerns about a Lehman-like repeat coming from a run on Europe?s banks. Draghi has put these fears to rest. They could of course reawaken, especially if some unforeseen accident causes Europe?s financial system to spin out of control. The collapse of Lehman, it should be remembered, was allowed by policymakers. AIG, in contrast, was bailed out because it was regarded as too big to fail. Lehman was allowed to fail because it was seen as ?containable? in an attempt to reduce the moral hazard cost created by excessive bailouts. In the end, it turned out to be an excessively harsh lesson for the world. European policymakers in particular see the way Lehman?s demise was handled as a major U.S. policy blunder. This has made them extremely reluctant to let big financial accidents run their natural course. Thus, barring an unexpected catastrophe, Europe will continue to keep its financial system on life support.
Volatility Collapses With ECB Liquidity Fix Click to expand
The substantially reduced risk of a European financial collapse is evident in the big drop in stock market volatility. In August, when European contagion fears were intensifying, the VIX rose close to 50, a level last seen during the 2008?2009 financial crisis. Standard & Poor?s 500 index, which had been over 1300 just a month before, was almost 20% lower during this time of heightened volatility. Another volatility spike in early October sent the S&P 500 briefly to a 2011 low just below 1100 before it stabilized.
Lower volatility could eventually reduce risk premiums and allow for higher stock prices. In fact, it already has.
By November 29, 2011, just before the cheaper dollar swap lines were announced, the VIX was already down in the low thirties and the S&P 500 was just shy of 1200, in anticipation of the pending policy changes. The more affordable swap lines and the ECB?s aggressive liquidity measures have since calmed the markets to a point at which the VIX is back to its normal position in the 10?20 range that this stage of the monetary policy cycle would normally dictate. Spurred by the resolution of the European liquidity crisis, this drop in the VIX by about a third during the last six weeks of 2011 was accompanied by a rise in equity prices.
Bottom line: The ECB?s new policy direction has helped reduce volatility to more normal levels for this phase of the business cycle. Lower volatility could eventually reduce equity risk premiums and allow for higher stock prices. In fact, it already has. Strong U.S. economic data, record corporate profits and falling unemployment should help equities as well. There is considerable room for U.S. capacity utilization rates to rise from here as the business cycle progresses. Rising capacity utilization rates generally raise profit margins, implying that they have yet to peak for this business cycle despite their already extraordinarily high levels.
Robert T. McGee is director of Macro Strategy and Research at U.S. Trust, Bank of America Private Wealth Management. In his career as an economist, he has been recognized by Bloomberg News, Businessweek, USA Today and The Wall Street Journal for outstanding forecasts accuracy throughout 1997 to 2007, including being ranked the No. 1 forecaster by The Wall Street Journal in July 2007.
Projections made may not come to pass due to market conditions and fluctuations.
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OTHER IMPORTANT INFORMATION
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