For much of past year, investors bemoaned the lack of a "bazooka" from the European Central Bank when it came to addressing the European debt crisis. It turns out the ECB had a stealth bomber waiting in the wings instead.
In December, the ECB channeled hundreds of billions of euros to the region's banks through a new program offering three-year loans at cheap interest rates. The start of that program has coincided with a sharp drop in short-term yields on the debt of some of Europe's most troubled nations, particularly Italy and Spain.
Some analysts say it is no coincidence. The program gave the market an important psychological boost by ensuring the region's banks had access to financing, but it may also have given it an important practical boost, too.
They say the central bank's program has enabled lenders to borrow cheaply from the ECB and use that money to buy higher-yielding government debt, pocketing the difference in yield. In December, the ECB provided 523 banks with €489 billion ($632 billion) of loans, of which €190 billion represented new money pumped into the financial markets. The ECB will offer more three-year loans under the program next month.
Skeptics say the benefits of the ECB's cash will prove to be a mirage. It's also unclear whether the improved tone in European bond markets could weather a collapse of talks to restructure Greece's debts. But at least for now the buying power may have helped push up prices of short-term sovereign debt and driven down borrowing costs. The yield on Italian two-year debt has fallen to 3.9%, from 5% just before Christmas and its peak of 7.8% in late November. Spanish-government two-year yields have fallen to 3.3%, from a high of 6.2%.
This unexpected rally has been magnified by buying by traders scrambling to reverse bearish positions. Many of those trades had been set in advance of huge amounts of bonds being sold this quarter by European governments.
And this turn of events has come without the ECB meaningfully stepping up direct purchases of Italian and Spanish debt, as many investors had called for.
"The market…was not thinking this was going to be quite the positive it's been," says Mohit Kumar, head of European and U.K. rates strategy at Deutsche Bank in London. The effect "has been much better than the market was anticipating."
While there are no hard numbers on the degree to which banks are recycling their borrowings into lending to sovereign nations, analysts at banks with the biggest European government-bond trading desks say this so-called carry trade has drawn the interest of lenders. Morgan Stanley analysts last week wrote that, based on "in-depth discussions" with 50 banks and policy makers, they expect banks to again borrow heavily when the ECB issues loans next month, possibly totaling as much as €400 billion.
They said a "reasonable number" of the banks were debating entering this carry trade. Spanish banks this year, the Morgan Stanley analysts said, could use that to buy €15 billion to €45 billion of Spanish government debt, absorbing as much as half of all Spanish bond issuance this year. Italian banks could buy more, the analysts said.
Significantly, the drop in bond yields has relieved the pressure on those countries, which were facing unsustainably high borrowing costs. At the same time, conditions in the interbank market, where banks lend to each other, have improved from last year, when it was largely frozen.
The ECB lending program essentially enables banks to turn bonds and loans on their balance sheets into cash by pledging them as collateral for the loans. Crucially, the ECB is allowing banks to pledge lower-quality debt than they would be able to offer elsewhere.
Banks can use the cash however they wish. Many are simply parking the money at the ECB, but market participants say others are employing a simple carry trade: The ECB currently charges 1% a year on its loans, but banks could pick up three to four percentage points more than that by buying short-term debt of some euro-zone governments.
"Earning 300 to 400 basis points of carry over a three year horizon is a very strong incentive for banks," says Deutsche Bank's Mr. Kumar.
Analysts say that, for the most part, banks have bought their home country's debt, possibly in order to stay in the good graces of their governments.
Skeptics say the ECB's long-term refinancing operation—widely known by its initials, LTRO—does nothing more than make the situation in Europe appear more stable than it really is. While it provides relief to banks struggling to raise cash, it doesn't address the considerable fiscal and economic problems afflicting the Continent.
Bill Gross at Pacific Investment Management Co. says it amounts to little more than troubled banks propping up the insolvent governments on which they rely. In December, Mr. Gross wrote, "What does LTRO stand for? 1. A shell game; 2. Cash for trash; 3. Three-card Monte; or 4. All of the above." Mr. Gross says that, despite the rally in debt of the weaker euro-zone economies, he stands by that statement today.
Huw Worthington, fixed-income strategist at Barclays Capital in London, says many long-term investors remain skeptical: "They don't think things have changed that much," he says.
read more: Olympus Wealth Management
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