Don’t Buy What Central Banks Are Selling

12/01/2011 10:50 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

The huge market move in response to the modest official intervention isn’t a great long-term sign, writes senior editor Igor Greenwald.

The rumor making the rounds yesterday was that the coordinated central bank intervention rescued a European bank from imminent failure.

That seems far-fetched. All the Federal Reserve did (with PR cover from colleagues in Japan, UK, Canada, and Switzerland) was cut European banks’ dollar funding costs by half of a percentage point of interest and push out the scheduled expiration of these credit lines from mid-2012 into 2013.

Once the new pricing takes effect next week, it should ease the severe strains in the European interbank lending market. But it won’t make any bank more solvent than it was on Monday, nor does it address either the underlying causes or the most glaring symptoms (higher yields) of the sovereign debt crisis.

So why the rumor? Because no one quite understands why this mostly symbolic and precautionary measure to unclog Europe’s financial plumbing should have rallied US equities 4%, taking commodities and overseas markets along for the ride.

The market slump into Thanksgiving came as European banks found it increasingly difficult to find affordable dollars for financing their short-term obligations. As Izabella Kaminska writes in the Financial Times, the European interbank market has been gravely compromised by a shortage of creditworthy collateral.

That’s why one of the most important changes made yesterday was the European Central Bank’s decision to reduce its collateral requirement on dollar loans from 20% to 12%, as pointed out by economist Karl Smith.

Yesterday’s action might have averted a greater breakdown, the morning after Standard & Poor’s downgraded a slew of money-center banks on both sides of the Atlantic. But the fact that we’re at this point is more important than what the markets did yesterday, and does not yet seem to have been discounted fully.

With the European banking system now sufficiently lubricated to survive for a month, European policymakers have a small window of opportunity to work out how the continent’s governments and banks will be refinance the trillions of low-interest debt maturing next year.

Their current plan is to put enough teeth into the widely flouted common budget rules to convince Germany to loosen the purse strings, specifically the European Central Bank’s. Without ECB help on a scale it has resisted to this point, Italy will have little choice but to default and exit the currency union. The ECB would need to contribute heavily to a bailout of Italy by the International Monetary Fund to make that rescue option credible.

Even if this game plan comes off without a hitch, investors will be left confronting a European recession and a slowdown in China. But at least the odds of a December wipeout have been cut. For the mercenaries driving the action in the stock market these days, that’s something.

Much of the smart money on the Street appears to be giving the rally little to no respect. From a contrarian perspective, maybe that’s a bullish sign.

I remain skeptical. Healthy markets don’t leap 500 points on rumors that a banking collapse has been averted. That’s a sign that things still aren’t right.

And as long as people are still buying into hopes of deliverance from on high, I’d rather be selling.

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