Markets Await Another Round of ECB Liquidity
The key event this week is Wednesday LTRO 2 injection of liquidity by the ECB.
The auction of 3-year loans at 1%, with relaxed collateral thresholds should help to further calm the European bond markets, which have responded positively to the first LTRO which totaled about €489 bn with near €250 bn of fresh money - that which wasn't being used to roll over some other shorter term debt.
Expectations of a huge uptake - double what we saw in LTRO 1 - have receded and the major trading desks and bank analysts now see total uptake that will be close to what we saw in December.
To the right I put a chart showing the impact on the ECB's balance sheet - as a percentage of GDP - from a €500 bn uptake or a €1 trillion uptake, with the consensus forecast currently around €470.
Here's a round-up of some projections for the LTRO 2 from a weekend Financial Times article as we opened the week.
From Financial Times: A month ago, some experts were predicting that the February auction would see banks bidding for as much as €1tn of ECB funding. The consensus expectation now appears closer to half that sum. Analysts at Morgan Stanley, for example, estimate that the February LTRO could add about €200bn to €500bn of net additional funding to the system, with another €100bn rolling in from other programmes.
UBS analysts expect to see €300bn of net new money, which translates to about €492bn after other programmes are rolled over. UniCredit analysts, meanwhile, expect gross demand of about €450bn.
Market participants can respond in two main ways to the release - use it as a catalyst to further the risk rally we have seen since January, or use this is an event to buy the rumor, sell the news and sell risk following this key event.
Response #1 - Will LTRO 2 Boost Equity & Commodity Markets?
First, there is the expectation that the cheap money will further help any lingering funding issues for European banks, putting them on firmer footing in the short to medium term, though still leaving vulnerabilities in the longer term. The response in equity and European periphery markets has been resoundingly positive to LTRO 1, and the possibility of further run-up in these risk assets on the back of cheap lending can help the bullish case - but would require a bigger uptake than the €500 bn expected.
Here's what happened with the EUR/USD after LTRO 1:
We can see here that even after the LTRO was auctioned off, the EUR/USD retreated further - a buy the rumor, sell the news response - though the early part of January coincided with downgrades for Euro-zone countries which helped to weaken the EUR. Eventually though, the stability that the LTRO provided to periphery bond markets was too much to ignore, and the EUR and risk turned around in January.
Here's the response to LTRO 1 in Italy's 10-year yield:
As we can see prior to the cheap lending, Italy's yields were rising to levels that would be unsustainable no matter what austerity programs the government undertook. Since the first LTRO, yields have retreated almost 180 basis points with Italian debt trading at 5.36% yield.
The key question is has most of the positive impact from LTRO and the expectation of LTRO 2 been priced in at this point, and can bond markets continue to see increasing demand (higher prices) which would let these yields fall further.
Response # 2 - Impact Priced In, Participants Worry About Bank Dependence on ECB
There is a danger that the market has priced in the positive impact of the LTRO 2 and may now see the dependence on the ECB for European banks as a bad thing, which may hinder risk sentiment and push down equities. Also, many of the effects of the LTRO 2 - especially in bond markets - may have come in anticipation of the event, and therefore may already be priced into markets.
Like at the end of QE1 and QE2 that did lead to big falls in equities (here the S&P 500) and we should be cognizant of a similar scenario playing out.
In a third interpretation, the increase in lending is tantamount to an expansion of the money supply (though to finance banks and not governments - meaning its not QE) which should weigh on the EUR.
Expansion of Global Balance Sheets Argue More for 1st Response Rather Than 2nd
Will LTRO 2 have a similar impact on the market as LTRO 1? One that gives the EUR more impetus to rise against the USD and others? Or, similar to the end of QE1 and QE2?
The extra boost to liquidity from the ECB's lending program, comes amid more quantitative easing by the Bank of Japan and the Bank of England, as well as a drop in China's bank reserve ratios which are all tools used to ease monetary policy and flood the markets with more cheap money.
Looking at the ECB's action in a wider context of this major factor, the increase in cheap money should continue to drive equity and commodity prices higher over the next months, as well as the EUR. The key question is whether the US Fed gets involved with another round of QE of its own. We will hear more from Bernanke this week as he testifies in front of Congress.
Nick Nasad is a macro-economic economist, analyst, and educator; and one of the main contributors to FXTimes - provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.
Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.