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ECB boosts shares, but for how long?

Chris Dillow

Chris Dillow
ECB boosts shares, but for how long?

Eurozone banks will get another huge cash injection next week, when the European Central Bank conducts its second three-year long-term refinancing operation (LTRO). The first LTRO lent banks €489bn (£412bn) and the confidence boost it provided has given equity prices a lift. But can the trick be repeated?

Since that first injection on 22 December, share prices in the eurozone have risen by more than 13 per cent, also driving up equity markets around the world. And the second tranche could have a similar effect. "We can almost certainly expect further equity market strength," says Rob Carnell at ING. He also expects the increased liquidity to encourage even more carry trades - borrowing at low interest rates (from the ECB) to lend at higher ones elsewhere. This, he says, will benefit the currencies of emerging markets and commodity-producing countries such as Australia and Canada.

The one thing LTROs don't seem to have done is to encourage ordinary bank lending. Official figures next week are expected to show that eurozone bank lending to the private sector fell in January for a third successive month.

But some economists warn that the ECB is simply papering over the cracks. Danny Gabay at Fathom Consulting points out that LTROs are not like quantitative easing (QE). Whereas QE gives investors cash for bonds, LTROs merely lend cash against the collateral of bonds. This means that asset price risk stays on banks' balance sheets, and if the prices of those bonds fall, banks could face a cash call from the ECB. LTROs, therefore, don't solve the problem that banks' capital bases might not be strong enough to absorb losses on southern European bonds. Banks' balance sheets, says Bob Janjuah at Nomura, are still "extraordinarily weak and fragile".

Worse still, says Mr Gabay, LTROs "could even be dangerous if they lull European politicians into a false sense of security" - into thinking that banks can withstand writedowns on bonds. He cites the precedent of 2008, when US Treasury Secretary Hank Paulson thought markets could cope with Lehman's collapse, only to swiftly learn otherwise.

Mr Janjuah says LTROs are merely creating a "liquidity-fuelled rally" in shares, commodities and lower-grade bonds which will collapse eventually. And when that happens, he says, it "will make 2008 feel, relatively speaking, like a bull market". He advises investors to hold on to gold, high-quality corporate bonds and non-financial blue chips.

See also: Beware of this bull market and Through the looking-glass of the ECB.

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