The last couple of eventful months have seen a significant change in market operators’ perceptions about the global economic recovery. Key macro indicators for most developed economies have taken a downturn to foretell growth deceleration into year-end and 2012. This lack of economic momentum has exacerbated ongoing tensions in financial markets, most notably in the eurozone. In the absence of a credible response from national governments to the sovereign debt crisis saga, the European Central Bank (ECB) had little option but to intervene in the secondary government bond market to defuse the ticking bomb that was threatening to blow up the single currency area.
ECB purchases in the secondary bond market proved successful, in so far as Italian and Spanish bond spreads versus the German Bund deflated from the perceived danger zone. However, in spite of this partial--and quite likely temporary--reprieve, other key signs of distress and distrust have been painting a rather alarming tendency; one that, if persisting, threatens financial markets with a major storm to significantly worsen the already downbeat opinions about the health of the economic recovery. Of all these signs, the one perhaps giving the greatest cause for concern relates to the potential for a new episode of interbanking lending seizure.
As the accompanying graph shows, eurozone banks’ recourse to the ECB overnight deposit facility shot up in August to an average daily amount of EUR 105 billion, a level not seen since mid 2010 and significantly higher than the EUR 20-30 billion recorded during most of 2011. This tells us that the ECB-engineered narrowing of Italian and Spanish bond spreads did not succeed in restoring confidence, as eurozone banks have opted to preserve capital rather than lend to each other.
The most immediate consequence has been that the EONIA (European OverNight Index Average), a eurozone money market rate used as a benchmark by a majority of eurozone money market ETFs, has fallen back to again track the ECB’s deposit rate (currently 0.75%). This has brought to a sudden halt--in fact, reversed--the gradual normalisation process (e.g. mean-reverting widening of the EONIA – ECB deposit rate spread towards the pre-crisis levels of around 100 bps) that had been taking place since late 2010. With the economic situation in a more fragile state than previously thought--not to mention the threat of a fresh interbank lending freeze--the chances of seeing eurozone money market rates normalise in the foreseeable future are fast diminishing.
All this spells further trouble for eurozone money market ETFs tracking EONIA. Indeed, with returns bound to fall below those offered by no-frills bank deposits, it is difficult to see how investors would choose these ETFs to park cash holdings. The mild uptick in assets under management in eurozone money market ETFs that we saw in late Q1-11 as money market rates rose to accommodate expected, and later realised, increases in ECB interest rates, has failed to curb the downward trend in net flows for this ETF category. Besides, with talk of the ECB either stopping or even reversing the mild tightening cycle while devoting their full attention to dealing with the intertwined sovereign debt/banking financing problem, it is difficult to harbour realistic hopes of a recovery in investors’ appetite for eurozone money market ETFs.
But of course, this situation has more far-reaching negative implications for investors than just the relatively unimportant irritant of unyielding money market ETFs. A eurozone inter-bank lending freeze would be a very unwelcome development at a time when the global economic recovery is stalling; not to mention the very negative effects it would have on the still much stressed sovereign debt market. Against this backdrop it would not be difficult to envisage increased inflows to safe-havens (e.g. German and US government bond ETFs, Gold ETCs).
One would hope to be wrong, but it looks as though a nasty autumn market storm is brewing.
