Fri 12/16/11 3:33 PM – ECB Finding a Back-Door Strategy to Prop Up Sovereign Debt

The European Central Bank (ECB) has refused to loan money directly to governments in order to bail them out or to buy more than limited quantities of their bonds. It has, however found a back-door way of doing the same. It is offering unlimited 3-year loans to banks and allowing them to use sovereign bonds as collateral. The banks thus gain the incentive to do the buying of sovereign debt.

For banks, buying Italian and Spanish sovereign bonds at 4% – 5% and borrowing for next to nothing from the ECB seems like a great deal. They pocket the difference on the interest, adding to profits. The sovereign debt markets get a fresh source of demand, pushing rates down for countries like Italy and Spain.

The question is, how long will this last? The ratings agencies will likely lower the credit ratings on sovereign debt fairly soon and the more banks borrow the harder it is for them to meet their new capital requirements. This phenomenon, like the coordinated central bank deal to loan each other unlimited amounts of dollars is probably another short-term boost. The underlying problem of slowing Eurozone growth and high deficits still exists. Some think the ensuing recession in the Eurozone could be deep.

We have lower than normal weightings to stocks right now, despite the fact that this is the seasonally strongest time of year for stocks. I may temporarily add to stock allocations but only for the short term. To me, this feels a lot like late 2007.

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