Forget earnings and valuations. If we’ve learned anything in the past three years, it’s that the timing and size of central bank liquidity injections are the most important drivers of market performance. And liquidity — or the lack of it — is about to become more important than ever.
On Wednesday, Feb. 29, the European Central Bank will release the second round of low-interest loans to the region’s banks under its so-called Long Term Refinancing Operation (LTRO) program. The announcement of that plan on Dec. 8 has helped spark rallies of over 8% in the S&P 500 Index and more than 12% for the iShares MSCI Europe Financials Sector Index ETF (NASDAQ:EUFN).
Investors have two important issues to consider as it relates to LTRO II. The first is whether next week’s injection can be expected to have the same positive market impact as December’s initial round. The answer is most likely no, since the date of LTRO II has been known well in advance.
Also, and perhaps more important, is the widespread speculation as to how large LTRO II is going to be. A recent UBS survey showed a consensus expectation of $668 billion, which would be larger than the initial round, while a separate Reuters poll shows many respondents expecting this round to exceed $1 trillion.
However, UBS itself sees the amount being closer to $300 billion. Its reasoning is that just because the ECB is making the cash available doesn’t mean the banks will take up the entire offer. The takeaway is that this round of LTRO has the potential to come in below expectations, whereas no such risk existed in December.
The End of LTRO?
That’s not all investors need to worry about. A much more crucial development was the news that emerged Tuesday in this Reuters report. The thrust of the story: The ECB wants this to be the last round of LTRO because it wants to avoid making the region’s banks and governments dependent on central bank largesse. This approach runs counter to the view HSBC expressed in a recent missive on the LTRO program, which opined that investors will need the promise of indefinite rounds in order for LTRO II to have a significant impact on market performance.
Why is this so important? Simply put, if the ECB pulls back on LTRO, there’s only a slim prospect of further central bank help in the immediate future. The U.S. Federal Reserve has offered no signs that it’s planning another round of quantitative easing (QE), and the Bank of England just boosted its own QE program on Feb. 9. And if recent history has taught us anything, it’s that a lack of support from the major central banks is death for the markets.
In each of the two periods between major central bank interventions — the gaps between QE1 and QE2 and from the end of QE2 to the beginning of LTRO — the S&P lost about 20%. In both cases, the problem was that the global economy had not yet reached a level of growth sufficient to support the markets absent central bank liquidity injections.
While the economic outlook is better now than it was on either of those two occasions, the markets haven’t demonstrated the ability to sustain continued gains without further central bank support. The burden of proof has now shifted to the bulls.
What to Watch
All that said, how can an investor monitor the markets for signs that underlying stress is beginning to build? While in the past bond yields in Italy, Spain and other peripheral markets could act as a guide, that might not be the case this time, based on this quote from the Reuters article: “If banks used the first LTRO to plug their funding needs and fend off a credit crunch, ECB officials hope they could use the second more aggressively to buy higher-yielding bonds, especially from Italy.”
This marginal buying may be enough to depress bond yields and make these markets a less effective indicator than they have been in the past.
As a result, investors may be better served by watching the measures known as the TED spread and the LIBOR-OIS spread. Both indicate the level of stress in European money markets: The higher these spreads, the greater the stress.
A look at the charts will show how both spiked between the end of QE2 (June 2011) and the announcement of the LTRO program (December 2011). Both charts are available via Bloomberg:
It may also pay to watch the behavior of EUFN with respect to its 200-day moving average. While the Select Sector SPDR-Financial ETF (NYSE:XLF) has been trading above its 200-day for over a month, EUFN is having more difficulty moving into bullish territory.
Watching charts like these is a different path to success than Benjamin Graham ever could have imagined. Still, the potential end of the LTRO program could be the event that derails the markets after three months of nearly uninterrupted gains.