Carry Trade

Analysts are questioning the "double-down effect" the ECB's LTRO exercises are creating in eurozone sovereign spreads. Citi notes a spike in the purchase of government securities since the initial take-up in December.

Rosie: "Somehow a long gold, short euro barbell looks really good here. Bernanke, after all, now seems reluctant to embark on QE3 barring a renewed economic turndown while the ECB is moving further away from the role of a traditional central bank to take on the role of quasi fiscal policymaking, The German central bank, after all, is responsible for 25% of any losses that would ever be incurred by the massive Draghi balance sheet expansion. Why would anyone want to be long a currency representing a region with a 10.7% unemployment rate, rising inflation rates and free money? Mind you — the same can be said for the US (where U-6 jobless rate is even higher), which is why the best currency may be physical gold."

American investor (and longtime CM.com member) Erik Townsend has spent the past several years living internationally, with an eye to which countries may be good alternatives if economic crisis and/or Peak Oil start to materially impact life in the US.  His main observation as an expat? Through its misguided policies, the US has been exporting inflation to the rest of the world, raising prices all over the globe (as an example, he cites a $57 chicken pot pie from the menu at a 'working class' restaurant in Australia).  This inflation is affecting the rest of the world harshly, but is not yet being felt in the US due to our ability to export it as the issuer of the world's reserve currency. Our immunity will not last forever though, and when it ends, a massive upwards spike in prices is going to hit US markets.

When explaining the practical effect of Wednesday's second and certainly not last LTRO, we said that "when it comes to explaining why Europe's banks are not only not deleveraging but increasing leverage while paying an incremental 75 bps on up to €700 billion in deposits soon to be handed over to the ECB, one needs all the favorable spin one can muster." We also estimated that net of rollovers and other tangents, the true net liquidity add would be €311 billion and "the final number by which the ECB's deposit account will increase will be about €210 billion less than the overhead number" of €529.5 billion. Sure enough, as of this morning, which takes into account the full settlement and allocation of the second LTRO cash installment, the ECB's deposit facility has soared by precisely as expected, rising by €302 billion overnight to an all time record of €777 billion, or just over $1 trillion. In other words, Europe has now successfully managed to fool everyone that it is executing the carry trade, when it is doing nothing like that at all, and it continues to park record amounts of cash with the ECB on which not only is it not earning a carry spread, but it is losing 75 basis points as it is paid a meager 0.25% for a deposit that cost it 1.00%. Said otherwise, instead of building a cash position and retaining earnings to fund €3 trillion in debt rollovers over the next three years (by the time the LTRO matures incidentally - good luck paying down that additional €1 trillion, which makes it a total of €4 trillion in maturing debt), roughly 800 European banks will bleed by €6 billion in the next year just to store their cash with the ECB. So much for promises of the carry trade. And we certainly commiserate with all those who bought European bonds on the assumption that they were frontrunning banks who are buying up BTPs, Bonos and what not. They were only frontrunning themselves.

The results for the second European 3 year discount window operation, pardon LTRO are in, and the winner is...

• ECB ALLOTS EU 529.5BLN IN 1,092 DAY REFINANCING TENDER
• ECB SAYS 800 BANKS ASKED FOR THREE-YEAR LOANS

Since the expected range was €200 billion - €1 trillion, and just above the median €500 billion, this is clearly within expectations, however notably less than what the Goldman investor survey expected at €680 billion. What is certainly scary is that the number of banks demanding a hand out was a whopping 800, well above the 523 from the first LTRO: clearly many banks are capital deprived.

There is broad disagreement among European banks on whether they should (and whether they will) choose to access the LTRO. We have discussed the top-down perspective and the very granular bank-by-bank perspective, and we end with a more bottoms-up perspective on the bank's own views of the LTRO. As SocGen notes, the investment banks (and certain Swedish banks) are very skeptical (and rightly so given the 'LTRO Stigma') while the Italian and Spanish are open to taking whatever they can, whenever they can (is that really a good sign?). Bank management must weigh the transparency they will face at the end of the quarter when sovereign bond holdings are exposed and just as SocGen points out, banks with considerably higher exposure (implicitly through the carry trade) may well face much more negative market action (even if Basel III doesn't handicap that risk). As with LTRO 1, the ECB will only reveal aggregate data, leaving the individual banks themselves to reveal their own take-up - we suspect the investment banks will make a point of highlighting that they did not take the funds, while the Portuguese, Italian, and Spanish banks will promote the benefits of their government-reach-around self-immolating ECB life-line.

So far there are no dramatic consequences of the Greek default.  The ECB did say they couldn’t accept it as collateral, but national central banks (including Greece’s somehow solvent NCB) can, so no real change.  We will likely get a Credit Event prior to March 20th once CAC’s are used to get the deal fully done.  Will the market respond much to that?  Probably not, though there is a higher risk of unforeseen consequences from that, than there was from the S&P downgrade. It just strikes us that Europe wasted a year or more, and has created a less stable system than it had before. Tomorrow’s LTRO is definitely interesting.  It seems like every outcome is now bullish – big take up is bullish because of the “carry” trade.  Low take up is bullish because “banks are okay”. Any weak bank looking to borrow from the LTRO to buy sovereign debt would be insane to buy bonds longer than 3 years and take the roll risk, but on the other hand, the weakest and most insolvent, got there by doing insane things in the first place.

Gaming out the impact of this week's LTRO2 demand on global risk assets is complicated by the ability of banks to mobilize collateral (how much can they pledge to the ECB and how much of that will be 'optimal' given the implicit subordination of senior unsecured debt holders), the use of those funds (carry trade economics are considerably lower and refinancing needs remain high), and the market's expectations (just how much more back-door QE is priced into European - and for that matter - US asset prices). Goldman Sachs surveyed its clients and found a gaping divide between banks and investors with the latter expecting considerably more than the banks - it seems someone will be disappointed - investors hope for more and banks expect to do less.

With the second version of the ECB's enhanced LTRO (back-door QE) starting tomorrow, there has been a great deal of speculation on what the take-up will be, what banks will do with the funds they receive, and more importantly how will this effect global asset markets. SocGen provides a comprehensive top-down analysis of the drivers of LTRO demand, the likely uses of those funds, and estimates how much of this will be used to finance the carry trade (placebo or no placebo). Italian (25%) and Spanish (20%) banks are unsurprisingly at the forefront in their take-up of ECB liquidity (likely undertaking the M.A.D. reach-around carry trade ) and have been since long before the first LTRO. On the other side, German banks have dramatically reduced their collective share of ECB liquidity from 30% to only 6%. SocGen skews their detailed forecast to EUR300-400bn, disappointing relative to the near EUR500bn consensus - and so likely modestly bad news for risk assets. Furthermore, they expect around EUR116bn of this to be used for carry trade 'revenue' production which will however lead to only a 0.6% improvement in sectoral equity levels (though some banks will benefit more than others), as they discuss the misunderstanding of LTRO-to-ECB-deposit facility rotation. We, however, remind readers that collateralized (and self-subordinating) debt is not a substitute for capital and if the ECB adamantly defines this as the last enhanced LTRO (until the next one of course) then European banks face an uphill battle without that crutch - whether or not they even have collateral to post. Its further important to note that LTRO 2 cannot be wholly disentangled from the March 1-2 EU Summit event risk and we fear expectations, priced into markets, are a little excessive. We suspect this will not be a Goldilocks 'just right' moment.

Overnight sentiment is significantly negative, with stocks, bond yields, risk currencies lower after G-20 over the weekend refused to increase IMF funding. The result is an end to the buoyant market sentiment of recent days which has seen the Dax down 1.2%, bund, UST yields lower, and US futures lower. As many had expected, the G-20 has rebuffed EU leaders' request for more assistance, which in turn has placed the onus on Germany to find a way to resolve its internal conflict vis-a-vis a Greek bailout, ironically as many believe that it is Germany who more than anyone wants Greece out. This happens as the Bundestag votes today on second aid package today; Merkel’s government must decide whether to back plans at this week’s summit to combine EFSF and ESM. In other news, tomorrow the ECB will call for bids for the second 3 Year LTRO tomorrow, with results announced on February 29. And with the ECB's deposit facility at €477 billion, it is rather clear that the banks will park the bulk of new proceeds with the ECB once again, where it will continue to be a negative carry trade, earning 0.25% at a cost of 1.00%. And somehow this is favorable for the European sovereign bond market, which continues to ignore the various layers of subordination it is now working under. We expect the market revulsion to this flaw to be violent when it comes, and will result in a rapid and sudden divergence between the various subordinated tranches of sovereign bonds.

The decoupling/recoupling we discussed earlier in the EURUSD pair seemed the biggest deal in Europe this week as the 2.5% gain is thge most in a month and takes the cross back to near 3-month highs. Not to be outdone, the VSTOXX (Europe's VIX equivalent) dropped notably and now stands at its lowest in 7 months - dramatically outperforming equity and credit markets on its way as selling vol appears the easiest trade ever (until of course your arms and legs are ripped off by a risk flare). Credit markets outperformed this week as equity underperformed - bringing the two asset classes closer into sync after last week's plunge in credit. Sovereign credit markets were mixed but clearly the high-beta compression trend has stalled as Portugal underperformed dramatically followed by Belgium with the rest generally tracking sideways (and Spain outperforming modestly). JPY weaknes balanced the EUR strength to keep the USD (DXY) from getting completely crushed on the week -1.35% (as Oil has rallied over 5%).

We have discussed forecasts for the second (and certainly not last ) February 29 3 Year LTRO in the past, with expectations for its size ranging from €1 trillion all the way up to a mindboggling €10 trillion. Today, Goldman has conducted a poll focusing on investors and banks, to gauge the sentiment for what has over the past 2 months been taken as the latest Deus Ex, which is really nothing than yet another bout of quantitative easing, only one in which the central bank pretend to be sterilizing 3 year loans by accepting any and virtually all collateral that banks can scrape off the bottom of their balance sheets (as a reminder, back in the financial crisis, Zero Hedge discovered that the Fed was accepting stocks of bankrupt companies as collateral - certainly the ECB is doing the same now). And once the banks get the cash instead of lending it out, or using it for carry trades, they simply use it to plug equity undercapitalization due to massive asset shortfalls on their balance sheets which are mark-to-unicorn^TM, yet which generate zero cash flow, even as banks have to pay out cash on their liabilities. In essence, the banks convert worthless crap into perfectly normal cash with the ECB as an intermediary: and that is all the LTRO is. Luckily, as we pointed out, even the idiot market is starting to grasp the circular scam nature of this arrangement, and the fact that it is nothing short of Discount Window usage, and because of that, the stigma associated with being seen as needing this last ditch liquidity injection is starting to grind on the banks. It is only a matter of time before hedge funds create portfolios in which they go long banks which openly refuse to use LTRO cash, and short all the other ones (read every single Italian and Spanish bank out there, and most French ones too) because at the end of the day one can only fool insolvency for so long. But once again we are getting ahead of the market by about 3-6 weeks. In the meantime, and looking forward to the next LTRO, whose cash will be used exclusively to build up "firewalls" ahead of the Greek default, here is what Goldman's clients expect to happen...

According to the WSJ, the “ECB is willing to forego profits on their Greek bonds”. That statement strikes me as one of the scariest things that a central banker could say (and there is some tough competition for that one). Forego profits? Here is the chart of a typical Greek bond over the past 2 years. The ECB started buying Greek bonds in May 2010, and stopped sometime in 2011. How do they possibly have “profits” to give up? They have “profits” because they live in an accrual accounting world. They buy bonds, don’t mark them, and accrue the interest. The accrued interest counts as “profit”. That is the carry trade. That is what everyone is so excited about for the banks. Banks can buy bonds, not mark them, and book the interest accrual (and payments) as profit. The problem with accrual accounting is when a sale is forced. Whatever the reason for the sale (in this case, a restructuring/default by Greece), the accrual accounting game is over and you have real profit or loss. The “profit” is the total proceeds received for the sale, versus total purchase price, plus any coupon payments received, minus costs of carrying the position. Some entity is taking the real world loss.

Since the start of the year, global markets have been apparently buoyed by the understanding that Draghi's shift of the ECB to lender-of-last-and-first-resort via the LTRO has removed a significant tail on the risk spectrum with regard to Euro-banks and slowed the potential for contagious transmission of any further sovereign stress. In fact the rally started earlier on the backs of improved perceptions of US growth (decoupling), better tone in global PMIs, and potential for easing in China and the EMs but it does seem that for now the ECB's liquidity spigot rules markets as even in the face of Greek uncertainty, as George Magnus of UBS notes, 'financial markets are most likely to defer to the ECB's monetary policy largesse' as a solution. Both Magnus and his firm's banking team, however, are unequivocal in their view that the next LTRO will unlikely be the last (how many temporary exceptions are still in place around the world?) and as we noted earlier this morning, banks' managements may indeed not be so quick to gorge on the pipe of freshly collateralized loans this time (as markets will eventually reprice a bank that holds huge size carry trades at an inappropriate risk-weighting) leaving the stigma of LTRO borrowing (for carry trades, substitution for private-sector funding, or buying liquidity insurance) as a mark of differentiable concern as opposed to a rising tide lifts all boats as valuations reach extremes relative to 'broken' business models, falling deposits, and declining earnings power.

They expect a EUR300bn take up of the next LTRO, somewhat larger than the previous EUR200bn add-on - but not hugely so - as the banks face a far different picture (in terms of carry profitability) and yet-to-be-proven transmission to real-economy credit-creation that will make any efforts at a fiscal compact harder and harder to implement as its self-defeating austerity leave debtor countries out in the cold. The critical point is that unless the market believes there will be an endless number of future LTROs, covering the very forward-looking private funding markets for banks, then macro- and event-risk will reappear and volatility will flare.

Did the first (of many) European LTRO buy just one month of marginal improvement? According to a compilation of analyst views by Bloomberg, who looked at today's mixed Spanish auction results when the country sold €4.56 billion of three-, four- and five-year government bonds, the easy money may have been made. Because while average yields fell for all three lines at the auctions, maintaining the trend at Spanish debt sales so far this year, it was the internals that showed weakness and could indicate that the marginal benefit from the first LTRO is now ending, even as the real task - the longer-dated bonds 10 years and great - still have to see much if any carry trade benefit at auction. Lastly, anyone hoping for a full carry flush from the European banks has to give up all hope: ECB announced its deposit facility usage rose to €486.4 billion, up €14 billion overnight. And with that we now know what the LTRO half-life is.