Following a relatively tiny two-day rally in the Euro the ECB blows its horn with a statement Credit Crunch Averted

The euro rose, extending its first weekly gain versus the dollar in six weeks, as Italian bonds advanced and after European Central Bank President Mario Draghi said policy makers have averted a credit shortage.

The 17-nation currency climbed against all but two of its 16 major counterparts as Spanish debt also rallied as Italy prepared to sell notes today. The Dollar Index (SPX) dropped for a second day before a U.S. report forecast to show consumer confidence improved this month, reducing demand for the U.S. currency as a haven.

Draghi said the central bank’s massive injection of cash into the financial system last month is beginning to flow through into credit markets. “There are tentative signs of stabilization of economic activity,” he said in Frankfurt after the ECB’s policy meeting yesterday. Policy makers kept the benchmark rate at a record low of 1 percent after two straight quarter-point reductions.

Draghi’s Statement in Perspective

After a 5-week decline, some snapback in the Euro is to be expected. The impetus is just as likely to be the action by the ECB to hold interest rates at 1% as anything else.

Actually, given extreme bearish sentiment on the Euro, no reason at all is needed for a euro relief rally.

For a look at sentiment including charts of record-high short interest on Euro futures, please see Euro Suffers Longest Losing Streak Since 2010; Record High Speculative Short Positions; Big Specs vs. Currency Movements; Not Timing Devices written January 8.

ECB Overnight Deposits Again Hit Record High

As for the idea a “credit crunch has been averted”, please consider the Wall Street Journal report for January 13 that says ECB Overnight Deposits Again Hit Record High

Euro-zone banks’ overnight deposits with the European Central Bank hit yet another all-time high Thursday, likely reflecting continued funding pressures in the banking sector as well as the approaching end of the reserve period.

Banks deposited €489.906 billion ($627.77 billion), the central bank said Friday, up from €470.632 billion Wednesday.

The daily deposits have been extremely high since banks in December tapped the ECB for its first-ever three-year loan. ECB President Mario Draghi Thursday said the extra long-term facility has been successful at preventing a serious credit contraction in the banking sector. The ECB launched the operation to address the fact more than €200 billion in bank loans was coming due in the first quarter, Mr. Draghi added.

Some analysts attribute that the ever-increasing deposits to the fact that banks are hoarding their excess funds—a good deal of which originate from the three-year ECB loan—by channeling them back to the central bank.

However, Mr. Draghi dismissed that idea at his press conference Thursday. He said the banks drawing on the ECB’s refinancing operation are “by and large” different from those banks that have been depositing their funds with the ECB overnight.

European Banks Hoarding Cash

European banks aren’t lending now, nor will they lend any time soon as discussed in German Economy Contracts in 4th Quarter; Spain’s Industrial Output Plunges 7%; UK Trade Deficit Widens; European Banks Wisely Hoard Cash

Skyrocketing ECB Balance Sheet

The reason for debt rally is not that a credit crunch has been avoided, but rather, the ECB has become the lender of only resort, bloating its balance sheet to record levels.

Please consider Swelling ECB Balance Sheet Brings Relief, Poses Risk For Euro

The European Central Bank’s increasingly swollen balance sheet has helped calm volatile markets, but some believe it could itself become a problem and bring more volatility to the 17-nation currency bloc.

Nearly a year’s worth of anticrisis lending measures have sent the ECB’s books to a record EUR2.73 trillion, some 29% of the euro zone’s gross domestic product. This expansion, capturing both the collateral pledged by banks receiving funds from the central bank and the sovereign bonds it has purchased for its own account, has been welcomed by bond investors, who see it as a stabilizing force. But the excess liquidity bodes for a weaker euro, and has some wondering if the ECB’s own solvency could eventually be in peril.

Many investors are concerned that a default in the Hellenic republic could ricochet across the 17-nation currency bloc. That could renew an assault on other euro-zone bond markets that are already distressed.

More worrisome are relaxed collateral rules. When the ECB introduced a three-year tender last month at generous 1% interest rates, more than 500 banks gorged themselves on a record EUR489 billion of the central bank’s cash. Some commentators worry that a worsening of peripheral bond markets could endanger securities pledged by the banks, posing a considerable solvency threat to the central bank.

“The quality of the balance sheet deteriorates as it expands, which is doubly problematic,” said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.

European banks are dumping sovereign debt at record levels on the ECB. Germany and France are on the hook. 10-year Italian bonds are down substantially, but the rate is still 6.5% with the ECB the buyer of only resort.

Good luck with that policy as Europe heads into a massive recession.

Mike “Mish” Shedlock
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