When Virtuous Cycles Turn Vicious

The LTRO's provided more than 1 trillion euros of liquidity. Spanish and Italian banks bought large amounts of sovereign bonds. Recent reports indicate in the Nov-Feb period, Spanish banks bought about 68 bln euros of sovereign bonds and Italian banks bought around 54 bln euros of sovereign bonds (mostly believed to be their own sovereign's). This helped fuel a decline in sovereign yields. The deluge of liquidity also helped lift the banks bonds and equities.

An under-appreciated aspect of the virtuous cycle, was the bank balance sheets improved not just because of cheaper cost of capital, but because there was a significant rally in the banks' assets--ie sovereign bonds.

Now things are in reverse and the virtuous cycle is becoming vicious. Spain's 10 year yield has risen about 115 bp since early March. Italy's 10-year bond yield has risen by about 100 bp since March 9.

The rise in sovereign bond yields has undermined the performance of European bank stocks. The Dow Jones Stoxx 600 band index (cap weighted) had rallied 40% from late-Nov '11 to the late-Feb-mid-March high. It has since sold off by almost 15% and appears to have been a major weight on other regional equities indices.

Owing to the linkages between public and private sector debt as goes European sovereigns so the banks. We have pointed out the underlying near-Ponzi type of scheme here whereby weak banks buy weak sovereign debt. When it works out, there is a positive multiplier effect. The problem is when it does not work out. Barring a fresh ECB initiative, it is difficult to see how officials break the vicious cycle.