Monday, March 5, 2012
With 2-yr swap spreads being key indicators of systemic risk and liquidity in the banking system, it is nice to see that U.S. spreads are back to what might be termed "normal," as the second chart shows; the U.S. has effectively decoupled from Eurozone risk. It's also nice to see that Eurozone swap spreads continue to decline on the margin (first chart), even though they remain quite high. The ECB's ongoing efforts to inject liquidity into the banking system with its 3-yr LTROs have added much-needed stability to the banking system, which in turn allows the economy to function and buys time so that market participants can redistribute risk. But of course this does nothing to alleviate the underlying problem, which is too much debt in some Eurozone economies, and too little ability to service that debt, absent some major structural reforms (e.g., big cuts in government spending and entitlement programs). Still, it is progress.
The Fed's efforts to provide dollar liquidity to the Eurozone have also been helpful, as reflected in the decline of Euro Basis Swaps, which in turn have proved to be a leading indicator of systemic risk in general. As the chart suggests, we should see some further decline in Eurozone swap spreads in coming months.
2-yr Italian and Spanish yields have declined significantly as a result of the improved liquidity conditions in the Eurozone. Ireland has benefited as well, but most of the improvement in the prospects for Ireland is due to painful but bold decisions last summer to implement needed fiscal reform (e.g., cutting spending). Greece of course has already defaulted, and Portugal remain quite likely to follow in its footsteps.
This chart, which includes data as of Jan. 31, 2012, shows that despite all of the ECB's liquidity injections, growth of the broad money supply in the Eurozone is not necessarily worrisome at all. Indeed, this chart suggests that the slowdown in M2 growth since the end of 2008 has been simply a reversal of the much faster growth in prior years. It's not surprising to see the slow growth in Eurozone M2 in recent years, since we know that money has been fleeting Eurozone banks for the relative safety of U.S. banks, and that has shown up as faster M2 growth in the U.S. (As a curiosity, I would note that the long-term growth of both Eurozone and U.S. M2 has been very close to 6% per year.) As has been the case with the Fed, the ECB has simply been supplying liquidity on demand, functioning as a "lender of last resort," which is proper. This has been carried out by effectively swapping bank reserves for longer-dated bonds of various sorts, thus satisfying an intense desire for liquid, safe assets. There has been no massive "printing" of money to date, which is why inflation remains relatively tame.
Posted by Scott Grannis at 1:30 PM