Bull Riding is Risky
By Fred Copper
January 24, 2012
Risk assets have jumped out of the gate in 2012 on stronger fourth quarter U.S. economic news, signs of monetary easing globally, particularly in China, and the liquidity facilities provided to euro zone banks by the European Central Bank (ECB) and the U.S. Federal Reserve. One of the most important actions taken by the ECB is the creation of a new liquidity facility for banks known as the Long Term Refinancing Operation (LTRO) which offers 3-year loans against a wide range of collateral. In the first auction, approximately 489 billion euros, a record, were borrowed by multiple banks. The second 3-year LTRO auction scheduled for February 29 could have substantially higher interest, as much as €1 trillion. This will represent a major de-risking of the banking sector and also a substantial backdoor Quantitative Easing (QE), providing a bullish tailwind to risk assets. However, there are two reasons why any continued run-up to that auction may be a good time to take risk off the table:
First, if ever there is a time to let Greece default, it’s after this auction and before the major EU-ECB-IMF (Troika) payment of almost €90 billion to Greece is due in mid-March. Greece has a €14 billion bond redemption on March 20 which they cannot currently fund. As such, the March bond redemption is implicitly the hard deadline for Greece. After the LTRO auction (which should have major participation thanks to some strong encouragement behind closed doors by EU officials), banks will be in as good a shape as they ever will be to withstand the fallout of Greek default. I don’t think it’s coincidental that the relaxing of the ECB’s collateral rules specifically include 10,000 new debt instruments, most of which were issued by French banks given their disproportionately large exposure to Greece. The fact that some form of agreement with private holders of Greek debt on a write-down is likely to be announced in the next few days does not alter the situation. This is the third round of the Private Sector Involvement (PSI) dance and there is no reason to expect this round to be any more successful or binding than any of the priors. The October EU summit set two broad targets for the PSI: 50% notional haircut on €206bn eligible debt targeted for the PSI and 120% debt/GDP ratio by 2020. Alongside these, the PSI was also deemed to be voluntary in nature. Since October more of the available debt has been transferred/sold into non-bank (and therefore non-coercible) hands such as private hedge funds. This creates the risk that participation rates will be well below what the EU wants and Greece desperately needs regardless of what is agreed to in principle.
Second, I think the transition of economic data from fourth quarter 2011 to first quarter 2012 is going to be unexpectedly severe. General deleveraging by governments and households, and 2012 demand pulled forward into 2011 to take advantage of expiring tax breaks, is likely to make first quarter 2012 economic data look particularly weak. Right now we are still riding the wave of positive fourth quarter 2011data, but around February we should start getting the first indications of presumed weakness.
This risk-on trend has a tailwind for the next few weeks as fourth quarter data continues to come in and as the implications of the LTRO auction become apparent. We discussed the positive implications of improved liquidity on risk premiums in the January 3 issue of Perspectives.
I think that auction could mark a turning point where the environment becomes considerably more hostile. Riding the bull market is fun, but keep in mind that falling off can be very dangerous.
The views expressed are as of 1/9/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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