In policy meetings during the Autumn of 2011, I started to warn of a growing state of dysfunction as some markets – such as for bank funding – closed completely, others saw bid-offer spreads widen and those firms perceived to be weak found their credit lines from fellow banks being cut. The situation was growing very dangerous. To a large extent it was the ECB three-year LTROs which dealt with that dysfunction – leading to the reopening of bank funding markets in particular.
So equity-linked structured notes, for example, have been out of fashion. High yield (non-financial) corporate bonds and Exchange Traded Funds (ETFs) have both been in. But since the risks in some ETFs were highlighted – by the UK’s new Financial Policy Committee amongst others – some of the more complicated ETFs and those with opaque securities lending programmes, have faded somewhat. It is not that investors are avoiding all credit risk – where it can be properly assessed and a diversified portfolio is possible. For example, the end-investor demand for corporate credit ex-financials is generally very strong. The announcement of OMTs by the ECB and the other announcements by the US Fed and the Bank of Japan, appear to have led to a collective sigh of relief in recent weeks. Yields on Spanish and Italian debt have fallen since the announcement – by 100bps or so at 10 years – and equity markets are up. I hope that the ECB action lays the foundation for a successful resolution of the European debt crisis. The view of markets so far is positive in that regard. I would caution, however, that we have been here before. Along with every other market participant I hope that this time will be different. But central banks cannot solve fundamental problems in the real economy, even using unconventional measures – they can only give the time and space for governments and private sector agents to do so.