In the second half of 2011, the twists and turns in the eurozone crisis dominated global markets to such an extent that nothing else seemed to matter. This remained true in January and February of this year, when the strong rally in peripheral bond spreads in the eurozone coincided with an equally strong rally in global equities. But in recent weeks, the umbilical link between the eurozone crisis and global risk assets seems to have broken down. As the graph shows, peripheral bond spreads (proxied by the average of Spanish and Italian spreads over German bunds) have returned towards crisis mode, while global equities have fallen only slightly.

Clearly, the success of the ECB’s liquidity injections, in the form of two massive LTRO’s amounting to a total of €1tn gross (€513bn net of maturing operations), have anaesthetised investors while many other aspects of the eurozone crisis, like sovereign bond spreads and the outlook for public debt ratios, have continued to worsen. A key question for the financial market outlook is whether this is just a temporary respite, or whether it represents a fundamental break in the eurozone’s power to damage global risk appetite.

It is important to be clear what the ECB’s actions, and the extension of the ESM/IMF firewall which has been announced in recent days, have actually accomplished in underlying economic terms. In both cases, and particularly in the case of the LTROs, they represent provisions of temporary liquidity for troubled sovereigns and banks, while having relatively little effect on the long run solvency of these entities.

It is true that the concept of illiquidity (ie whether you can pay your bills tomorrow) is difficult to separate completely from the concept of solvency (ie whether you have positive net worth in the long run). As we saw last year, illiquidity in the bond markets can cause higher yields which can tip a government from a good equilibrium into a bad equilibrium, in which the sovereign suddenly looks insolvent. But the two concepts are nevertheless very different in most circumstances.

The ECB’s actions have greatly reduced the chances of illiquidity in either the sovereign bond markets or the eurozone financial sector for some time to come. Banks have been given a free option to pre-finance all of their liquidity needs for a 3-year period. It would have been remiss of them to decline such a generous offer from their central banks, and they have not done so. According to the IMF, LTRO funding covers more than 60 per cent of banks’ debt maturing in 2012, making it far less likely that they will have to de-lever their balance sheets in emergency conditions to keep their doors open.

Furthermore, €115bn of the money borrowed in LTRO’s has been allocated to new government bond purchases in the form of a “carry trade” by the banks concerned, and this has also helped to alleviate the funding problems of troubled sovereigns, particularly Spain. About half of the Spainish government’s gross funding needs for 2012 have already been covered.

ECB President Mario Draghi has given no indication that any further LTRO’s are planned, and he distanced himself from IMF suggestions this weekend that more will be needed. But the market now knows that the ECB has a revealed preference for massive liquidity injections if crisis conditions should return to the financial system. This greatly reduces the market’s perception of bankruptcy risk in the eurozone banking system, now and in the future. And the possibility of ESM or IMF programmes of assistance for sovereign financing also lurks in the background.

Does this therefore mean that investors can now relax about the underlying worsening in the solvency of eurozone governments, which still appears to be underway, owing to sharply weakening economic conditions in the peripheral countries? That is a very difficult question to answer. Clearly, the bar to another major crisis has been raised very substantially. However, the risk has not been eliminated entirely.

Although the primary market financing needs of both banks and governments have probably been covered for some time to come, trouble could still arise in two different ways.

First, sales of sovereign bonds in the secondary market could still cause losses in the market value of the sovereign debt held on bank’s balance sheets. This danger has actually been increased by the LTRO’s, since bank holdings of domestic sovereign debt have increased. Again, this has been particularly true in Spain. While domestic banks do not seem likely to shoot themselves in the foot by dumping their own sovereign bonds in large amounts, foreign investors might yet do so. And foreign investors still hold 35-40 per cent of Spanish and Italian government debt, so they can still cause a lot of trouble.

Second, and more importantly, the LTRO’s do not solve the capital and regulatory problems which are plaguing the eurozone’s banking sector. Even if the banks are in no danger of immediate liquidity problems, they might still be forced to delever their balance sheets in order to meet the new capital requirements which regulators are imposing on them. This could lead to a drop in credit availability, especially in the peripheral economies.

The IMF’s Global Financial Stability Report, published last week, attempts to estimate how damaging bank deleveraging could turn out to be for the eurozone economy. Their conclusion is that, on current policies, the supply of credit will fall over the next two years by 4 per cent in Spain, 3 per cent in Italy and 2 per cent in the eurozone as a whole. These adverse credit effects are already included in the IMF’s baseline economic forecast, which shows recessions of varying depths in eurozone economies this year. But the IMF warns that, in an environment where the eurozone’s policy determination begins to waver, the provision of credit could worsen further, knocking another 1.4 per cent off the GDP growth forecast.

This would turn a mild recession into a deep one, an outcome which would very quickly restore the power of the eurozone to shock risk appetite across the global financial markets.

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