World finance: Will the risk rally last?

Risky-asset markets have made big gains since the start of the year, recouping part of the losses seen in the second half of 2011. The rally started in equity markets but has broadened to encompass credit markets, commodities, currencies and emerging-market assets. Although serious threats to this rally remain – most notably in the form of concerns about the effectiveness of policy efforts to stabilise the euro zone – for the time being there are a number of reasons to expect the surge in risk appetite to continue.

The most important factor in the rally in risky markets has been the European Central Bank’s offer of cheap three-year loans to euro zone banks in late 2011. Banks took up almost the entire allotment of funding (€489bn out of a total of €500bn). After taking into account repayment of short-term ECB funding, a net €200bn (US$260bn) was injected into the euro zone financial system in December. The ECB has announced that it will make another offer of three-year repos in late February.

The ECB repos have eased conditions in funding markets for peripheral banks and sovereigns. Euro zone banks from core countries have issued unsecured debt for the first time in several months, and Spanish banks have issued secured debt. Fears that euro zone banks would not be able to roll over an estimated €600bn in long-term debt repayments in 2012 have receded.

Crucially, the improvement in bank funding markets is filtering through to sovereigns. Italy is a particular concern, as the government needs to raise around €320bn this year, including €97bn to cover bonds falling due between February and April. Yet Italy and Spain have seen borrowing costs at auctions of short-term money halve from the levels paid in December. And auctions of 7-year and 10-year Spanish bonds have met with higher demand than expected.

Article from: