Why the bail-out rally might be short-lived

“Markets rocket on bailout package”… “FTSE 100 closes up 8.84% – biggest one-day gain ever”… No, these aren’t today’s headlines. They’re dated 19 September 2008, just after the US government came up with a $700bn scheme to bail out the country’s banks after the subprime mortgage meltdown.

And clearly, the markets liked what they saw – for about 24 hours. But what happened next? Here’s how the FTSE 100 then reacted:

Source: Bloomberg

That huge one-day surge was followed by an even bigger dive. Within six months, the index had plunged by over a third. Investors clocked that the bail-out package wouldn’t solve underlying problems.

It took an even larger $1 trillion rescue plan in March 2009 to restore investors’ confidence in shares. Eventually, the Americans threw so much money at the markets that asset prices had to recover. But even now, the FTSE 100 has only just regained its September 2008 levels.

So what will happen this time?

The latest €750bn European Central Bank (ECB) package is a straight swap. Instead of US subprime lenders being funded by the Fed, this time it’s the PIIGS (Portugal, Ireland, Italy, Greece, Spain) that are being bailed out by the ECB.

Clearly, today has seen a big burst of short-term relief in the markets. What’s more, a lot of ‘short’ positions, where traders have sold in the hope of buying back lower down, are being closed out. That has squeezed prices higher.

But further out, will being bailed make Greece more likely to cut back its borrowings? Somehow I don’t think so. As Wolfgang Munchau says in the FT, “the time will come when throwing money at problems without structural change will cease to work, and even to impress”.

Quite. And when investors rethink, they may well decide they’re not at all convinced about this latest bail-out. Just as in September 2008.