ECB Waiting for Second 3 Year LTRO

The big deal this month is the ECB’s 36-month LTRO with allotment on 29 February. We expect the Governing Council to wait for the outcome of this operation before they decide whether more measures are needed. In other words, we expect unchanged interest rates and no new instruments at tomorrow’s meeting.

The first 3Y LTRO was, in our opinion, incredibly important and has been very successful. Sovereign spreads in both Italy and Spain have narrowed significantly and a relief rally has been seen in many asset classes. The second 3Y LTRO could add more fuel to the fire.

We do not expect the ECB to make an announcement on its holding of Greek bonds though it will be an issue in the Q&A. It is increasingly likely that the ECB will accept selling the bonds at purchase price.

Market reaction is set to be muted if the ECB keep rates unchanged. A rate change or new instruments would be a major surprise and the market would react accordingly. 

Draghi set to remain alert

Since the last Governing Council meeting, we have seen relief in financial markets and improvement in activity indicators, most notably the PMIs, which Mario Draghi seems to be watching carefully. However, at the same time, the ECB’s bank lending survey points to substantial credit tightening and recent German macro data have disappointed. For now, the need for further ECB action has probably diminished, although the Governing Council is expected to remain alert. We therefore expect tomorrow’s meeting to be somewhat dull with Mario Draghi emphasising signs of reduced stress in financial markets, but also focusing on the risks related to the ongoing debt crisis as well as credit tightening caused partly by the need to improve capital ratios to achieve the 9% core tier 1 capital ratio target by the end of June. We expect the ECB to keep the refinancing rate unchanged at 1% throughout 2012 and 2013.

36-month LTRO

The big question is how much money the banks will take at the second LTRO. A substantial take-up will add to excess liquidity and would be likely to keep the current relief rally going in the absence of a worsening of the debt crisis dynamics. 

At the December 36-month LTRO, banks took EUR489bn. As a result, excess liquidity now stands at a record high EUR471.9bn. And large amounts have to end up as deposits at the ECB, which pays a tiny 0.25% in interest. This could potentially dampen the interest in taking even more money at the second LTRO. However, the banks that deposit are not the same as those that use the LTRO. The circuit is this: weak banks having difficulties borrowing in the market use the LTRO. They buy assets, pay back loans, etc, and the liquidity eventually ends up in stronger banks. These are flooded with liquidity and having no better place to put it (they won’t lend it to the weaker banks) they place it on the ECB’s deposit. It is thus important to focus on whether weak banks can use more three-year liquidity and not whether the whole system does. We think they do.   

There is a real risk that concerns about stigma could stop banks from using the LTRO. The risk that banks will focus on the stigma increased when Deutsche Bank’s CEO Joseph Ackermann said that it did not use the December 3Y LTRO and is reluctant to use the February 3Y LTRO for reputational reasons: “The fact that we have never taken any money from the government has made us from a reputational point of view so attractive to so many clients in the world that we would be very reluctant to give that up”. The reputational risk argument could be strengthened by the financial circuit described above, which increases the likelihood that it is primarily weak banks that will take additional capital at the second LTRO. As a result, some banks will abstain from using the 3Y LTRO. Nevertheless, three-year liquidity at the refinancing rate seems a very good deal for most banks even if you factor in some reputational risks. 

On 1 March, EUR49.7bn in a 6M LTRO matures and EUR38.6bn in a 3M LTRO, which could be rolled into the 3Y LTRO.  All in all, we expect banks to take around EUR300-600bn at the 3Y LTRO. According to Reuters, forecasts now range from EUR75bn to EUR800bn and there is still talk of EUR1trn. 

We do not expect the ECB to announce more 3Y LTROs at future meetings. If the February 3Y LTRO is a success, there will be so much liquidity around that new long LTROs should not be needed for a while, and if it fails to attract interest because of stigma concerns the ECB will instead look for other instruments.

ECB's holdings of Greek bonds

A haircut on the ECB’s holdings of Greek bonds could help to improve Greece’s fiscal sustainability. However, the ECB does not intend to participate in the Private Sector Involvement (PSI). Since the last meeting, talks about Official Sector Involvement (OSI) have gained traction and it now seems that the ECB has accepted not to make a profit on its holdings of Greek bonds, though it will not accept to take a loss on its rescue operation. The ECB is thus likely to accept a write-down of the bonds’ principal or sell its bonds at purchase price either to the EFSF, ESM or Greece. The exact details on how and when this will be done are not known, but it should be done in such a way that it causes an immediate decline in Greece’s government debt.