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LTRO Will Help Short-Term Funding, But Backdoor QE It Probably Is Not
By Mark Gongloff
- Reuters
- ECB President Mario Draghi
One of the things driving the market higher today is the idea that tomorrow’s Long Term Refinancing Operation by the ECB will serve as a back-door QE, bailing out the sovereigns and helping banks earn some easy cash with a carry trade.
The idea is fairly simple at first blush: European banks buy high-yielding sovereign debt, which they can pledge as collateral in the LTRO (of which there will be others in the future). The LTRO gives them cheap cash they can use to buy still more high-yielding sovereign debt, pocketing the yawning difference in borrowing costs.
This might help explain why recent auctions of peripheral European sovereign debt have been so well-received — banks were planning to turn right around and offer them to the ECB as collateral in exchange for a cheap loan.
Sounds good so far, but there are complications. Investors, already jittery about European banks, might balk if those banks take their cash and buy too much risky sovereign debt — against which they will also have to hold capital.
Peter Tchir of TF Market Advisors figures this will really end up solving a funding problem for the banks — as advertised, in fact — rather than waving a magic wand to resolve solvency problems of both sovereigns and banks:
Banks are struggling to borrow money right now to finance their existing positions. How much of LTRO will be used to finance new bond purchases, rather than to replace existing forms of funding? Any bank that is already running a big sovereign debt position will look to LTRO to replace existing forms of financing. They can eliminate the repo roll risk on bonds they are financing in the repo market, or they could stop attempting to borrow in the interbank market. Those are positives for the banks as they can earn more carry (cheaper financing) and reduce roll risk (3 year term). But that doesn’t create new demand for bonds.
So the LTRO can help the banks with their existing funding problems without a doubt, but it is unclear that encourages new bond purchases.
Banks will have no real reason to buy up more sovereign debt, he suggests — particularly since they already own a lot:
To buy now, you need to believe that the default risk is gone. Since NOTHING about this program addresses solvency, you cannot change your default assumptions. You would be betting that the problem is really liquidity driven and that this program can solve that. But how can you know that? You need to assume every other bank will add significantly to their exposure. No one bank can grow their exposure too large, without losing all access to the public debt markets and seeing their share price drop. So each bank can only add incrementally. Since the solvency problem hasn’t been addressed, you are buying in the hopes that some other bank buys too. If everyone buys and takes on even greater exposure to these weak countries, then the liquidity and debt issuance risk can be addressed. But what if strong banks don’t think it is smart to take on more risk.
Thus he thinks tomorrow’s LTRO will mainly be used for current financing needs, rather than taking big risky bets:
There will be significant interest in tapping the LTRO for existing positions. Some small amount of incremental purchases may occur at the time, but the banks will use this to finance existing positions. This should help bank credit spreads. It should also show up in measurements like OIS as it would reduce pressure in the interbank funding market. This is positive, but a relatively minor positive, and seems more than priced in.
Lisa Pollack at FT Alphaville had a very good post yesterday putting into perspective just how large the current funding needs of the banks already are — a hole that the LTRO will help plug, but not much more — certainly not embarking on a risky carry trade.
Marc Chandler agrees that this is no Trojan horse bearing QE:
Following the 1-year repo in June 09, there had been market talk of the money going into the short-term Italian and Spanish bonds. Yet we don’t expect as much of new carry trades some officials might wish. The lion’s share of the funds LTRO taken we suspect will go to 1) replace current ECB funding, 2) build greater cash buffer and 3) reduce some liabilities. To the extent banks buy sovereign bonds, we think they are more likely to buy domestic bonds than foreign bonds. The slope of curves may be an important consideration in whether banks take some duration risk.
But Chandler also thinks huge bank participation — something on the order of 250 billion to 500 billion euros — in tomorrow’s LTRO will be taken as a risk-on sign by the markets anyway.
Nomura currency maven Jens Nordvig, who recently closed his short-euro position when it dipped below $1.30, thinks it best for euro bears to step aside until the LTRO dust settles:
We have squared up our short EURUSD exposure at 1.30 last week, and we are in no major hurry to get back in. In the first instance, we will re-assess after the LTRO results are out tomorrow, but it may be better to wait patiently for fresh opportunities in January.
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