For the most part, global markets posted very modest gains for the week. Yet again, the big market driving news of the week came from a central bank. This week it was the European Central Bank (ECB) and their most recent lifeline to the banks in Europe.
On Wednesday we awoke to the news that Europe opened a second tranche of its Long-Term Refinancing Operation (LTRO) to European banks. Simplistically, the LTRO is an offer of low interest (1%), three-year loans to banks in Europe. The first LTRO was done in the end of December 2011 to the tune of 489 billion Euro, and offered to 523 banks; all 523 banks took the loans. Wednesday’s LTRO was 504 billion Euros and was gobbled up by 800 banks. Hold your applause. Consider a few items regarding the injection of more than $1 trillion dollars (504 billion and 489 billion Euros is worth well more than $1 trillion dollars) being pumped into European banks within a three month period.
The first item to consider is that a big part of the purpose for the LTRO is to provide liquidity to the banks in Europe so that they will either refinance their maturing debts at lower rates, or perhaps loan the money out. Borrowing cheaply and re-loaning the funds at a higher rate is called carry trade. Banks can borrow from the LTRO at 1% and, if they thought it was prudent, loan it out at a higher rate and profit from the difference. The problem is that banks in Europe are not doing either of these. The European banks are instead re-depositing the funds in the ECB Deposit facility where those borrowed funds earn next to nothing. In other words, the banks that opted into borrowing from the LTRO at 1% are parking the money at a lower rate. This means the banks would rather hoard the money at a loss then loan it out.
To explain the other problem with the LTRO, I will let the folks at Canadian fund manager Sprott Asset Management do the honors. The following is from the monthly newsletter from Sprott (original found here) and I would encourage any interested party to spend 10 minutes reading it). Sprott’s article was written before the 2nd LTRO was done.
“First and foremost, without continued central bank support, interbank liquidity may cease to function entirely in the coming year. Consider the implications of the ECB’s LTRO program: when you create a loan program to save the EU banks and make its participation voluntary, every one of those 523 banks that participates is essentially admitting that they have a problem. How will they ever lend money to each other again? If you’re a bank that participated in the LTRO program because you were on the verge of bankruptcy, how can you possibly trust other banks that took advantage of the same program? The ECB’s LTRO program has the potential to be very dangerous, because if the EU banks start to rely on the loans too heavily, the ECB may find itself inadvertently attached to the broken EU banking system forever.
The second unintended consequence is the impact that interventions have had on the non-G6 countries’ perception of western solvency. If you’re a foreign lender to the United States, Britain, Europe or Japan today, how comfortable can you possibly be in lending them money? How do you lend to countries whose sole basis as a going concern rests in their ability to wrangle cash injections printed by their respective central banks? Going further, what happens when the rest of the world, the non-G6 world, starts to question the G6 Central Banks themselves? What entity exists to bailout the financial system if the market moves against the Fed or the ECB?
I am still of the mind that capital preservation and purchasing power preservation is of utmost importance in the current economic landscape. In addition, we must all keep in mind the analogy of a butterfly flapping its wings and impacting something on the other side of the earth. There are many economic butterflies fluttering about these days that could unleash unpleasant surprises – oil prices, Iran, Syria, Greece, European Banks, US debt overhang, US election, China…
I will wrap-up this week’s commentary with a very prophetic quote:
“Endeavors to keep the rate of interest below the height it would attain on a market not sabotaged by credit expansion are doomed to failure in the long run. In the short run they result in an artificial boom which inevitably ends in a crash and slump. The recurrence of periods of economic depression is not a phenomenon inherent in the very course of affairs under laissez-faire capitalism. It is, on the contrary the outcome of the repeated attempts to “improve” the operation of capitalism by “cheap money” and credit expansion. If one wants to avert depressions, one must abstain from any tampering with the rate of interest.” – Ludwig von Mises – The Theory of Money and Credit – 191
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John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit https://www.chladekwealth.com.