One of the things we’ve been defending against over the last few quarters is a rise in system risk. In particular the European banking system has been under fire, and for many months we’ve been watching sub surface risks rising in the credit markets. Bank lending is what moves world growth, so the idea that a banking crisis could lead to a seize up in world trade has been no small risk to defend against.
Recently we’ve been watching some measures of system risk pull back, which is very good news. One metric I’ve been focusing is the cost of dollars in the market place. Not long ago the cost of accessing dollar funding was approaching the 2009 highs, which was problematic for financial institutions that need them every day to settle dollar-based transactions. But during late November and December, a few things happened that may have changed the game for a while, at least when it comes to the liquidity crunch within the European banking system.
At the end of November, central banks engineered a coordinated swap line that provided cheap access to dollar funding. Then in December the ECB instituted a collateralized loan program allowing financial institutions to borrow for up to three years in unlimited quantities. This program was massive and essentially gave the banks a chance to trade very questionable collateral for the cheap capital they desperately needed.
Obviously, the combination of these two ideas don’t solve all of the world’s problems. They don’t reduce the amount of debt in the system, they won’t prevent rating agencies from future downgrades, they don’t keep the banks from parking funds at the ECB, and they don’t take away the recessionary growth profile in Europe. But what they may be doing is taking out the fat tail risk of another banking crises while simultaneously injecting a new round of high powered liquidity into the marketplace. With less banking risk and more liquidity, the potential exists for a reflationary impulse to ignite another bout of cyclical asset inflation, even in a structurally challenged world. As system risk recedes, we are reevaluating our entire allocation with an eye to defending against fat tail potential in both directions.
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