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EURUSD Is Vulnerable Ahead Of 'LTRO Friday'

Tyler Durden's picture




 

ECB will release data on the early LTRO loans repayment tomorrow. The release will help gauge the liquidity needs of the European banking sector and the prospects for a further reduction in Eurozone excess liquidity from here given that the repayment of LTRO loans will likely continue over a period of time. Consensus expectations seem to be centered around EUR100bn. Recent EURUSD resilience appears based on the market's growing concern that LTRO repayments will be larger than expected (thus reducing the ECB balance sheet / tightening more than expected) and driving up the EUR vs the USD (e.g. ECB vs Fed balance sheet). Critically, as Citi notes, the repayment of LTRO loans will free up collateral in the form of peripheral bonds. This seems to be particularly the case ahead of tomorrow given that Spanish and Italian banks were among the biggest borrowers under LTRO’s first tranche. If these banks opt to benefit from the spectacular rally in BTP and Bono markets and liquidate some of their LTRO collateral (and shrink their balance sheets in the process) this could fuel renewed upside pressure on the peripheral bond yields. This could then dampen any EUR upside post LTRO repayment - and as the main carry-driver for US equity performance, could lead to a risk-off switch quite rapidly. So tomorrow's LTRO repayment needs to be Goldilocks - too little and its clear banks have liquidity problems still; too much and the market's reaction could be notably risk-off.

 

Authored by Valentin Marinov of Citi,

Hopes for sizeable LTRO repayment leave EUR vulnerable

  • Markets could be positioning for a larger LTRO repayment amount than the EUR100bn currently anticipated by the market.
  • This could mean that EUR would trade in buy the rumour/sell the fact fashion with investors taking profits on euro longs in the aftermath of the release.
  • The higher EUR movers across the board the greater would be the negative kneejerk reaction to a smaller than expected LTRO repayment.

EUR remained well supported across the board despite a mixed bag of Eurozone data and renewed indications that Germany maybe unhappy about the latest price action in EURJPY. EUR resilience seems linked to tomorrow’s announcement of the early repayment of the LTRO loans by European banks. With the euro so bid against higher yielding currencies like AUD and NZD and European short-term rates still bid we suspect that markets could be positioning for a larger LTRO repayment amount than the EUR100bn currently anticipated by the market. Corroborating this view seems to be the fact that EURGBP surged after headlined about a large UK lender looking to repay almost all of its LTRO loans in February hit the screens.

Being long EUR may seem like a reasonable bet at present. If the LTRO repayment amount indeed exceeds market expectations and comes in at say EUR150bn, Euro rates and EUR could go higher from here as investors bet on further aggressive withdrawal of liquidity and contraction of the ECB balance sheet (see also Figure 1 and 2). The EUR-funded carry trades put in place on the back of further ECB easing by the ECB could suffer more as a result. At the same time, a smaller than expected LTRO repayment amount (say 50bn) could be in part explained by the fact that this week is only the first of many when the European banks can repay the ECB loans. Markets could thus opt to ignore a smaller than expected number and EUR-downside need not be pronounced.

With EUR having moved to new multi-month highs against sterling and CAD and now trading close to recent highs against USD, JPY, AUD and NZD, it seems that the market may have priced in a more sizeable repayment amount to a certain degree already. In turn, this could mean that EUR could trade in buy the rumour/sell the fact fashion with investors taking profits on their euro longs in the immediate aftermath of the release. This also means that the higher EUR movers across the board the greater would the negative impact from a smaller than expected LTRO repayment amount be from here.

There are other reasons to expect that any EUR upside on the back of larger LTRO repayment amount could be only temporary. As argued in "EUR ahead of LTRO" (below) Friday published yesterday the repayment of LTRO loans will free up collateral in the form of peripheral bonds. This seems to be particularly the case ahead of tomorrow given that Spanish and Italian banks were among the biggest borrowers under LTRO’s first tranche. If these banks opt to benefit from the spectacular rally in BTP and Bono markets and liquidate some of their LTRO collateral (and shrink their balance sheets in the process) this could fuel renewed upside pressure on the peripheral bond yields. This could then dampen any EUR upside post LTRO repayment.

EUR ahead of LTRO Friday

  • The LTRO repayment on Friday will affect ECB’s balance sheet and short-term rates. It will free up collateral, can weaken domestic demand for peripheral debt and push peripheral sovereign yields higher. Our results suggest that EUR could be driven by the response of the peripheral bond markets and less so by the response in short-term rate markets.
  • Smaller than expected LTRO repayment (less than 100bn) could the short squeeze in Euro FI to a halt and weigh on EUR. The downside need not be pronounced if peripheral spreads keep tightening, however. Larger repayment could support EUR via higher rates but only if the repayment does not trigger renewed increase in the peripheral bond yields.

ECB will release data on the early LTRO loans repayment on 25th of January. A month later, the banks will have another opportunity to repay LTRO loans taken up as part of the second program announced in February 2012. The release will help us gauge the liquidity needs of the European banking sector and the prospects for a further reduction in Eurozone excess liquidity from here given that the repayment of LTRO loans will likely continue over a period of time. Market expectations seem to be centered around EUR100bn. Citi’s economists expect repayments between EUR50bn-100bn.

 

The overall impact from the LTRO repayment on EUR will go through two channels:

1)     The first is the impact of LTRO repayments on the size of the ECB-balance sheet and the short-term Eurozone rates. A sizeable drop in the ECB balance sheet and Eurozone excess liquidity could be seen as supportive for EUR against currencies where the market is expecting central bank balance sheet expansion like the Fed, the BoJ and the BoE. In Figure 1 we plot EURUSD against the ratio of ECB and Fed balance sheets. The historic relationship would suggest that aggressive shrinkage of the ECB’s balance sheet relative to Fed’s could be EURUSD positive. In Figure 2 we plot EURUSD against EUR-USD 2y swap rate differential. If the LTRO repayment fuels further short-covering in European FI this could lead to wider rate spread and thus higher EURUSD.

 

 

2)     The LTRO loan repayments will also free up collateral in part in the form of peripheral government bonds. In turn, this could weaken the domestic demand for Bonos and BTPs and add to the upside pressure on peripheral bond yields. As shown in Figure 3, the EURUSD rally over the last few months was driven by sharp tightening in peripheral bong yield spreads to Germany. If that process slows down and even goes into reverse as a result of the LTRO repayments, with foreign investors too slow to fill up the gap in demand, this can add to the EUR headwinds. If, however, foreign investors buy peripheral debt at more attractive levels, the impact on EUR need not be pronounced.

 

 

Possible outcomes:

1)     LTRO repayment of less than 100bn could dampen the latest pick up in the Eurozone short-term rates and add conviction to the view that the ECB balance sheet would shrink only gradually over time. Given the close correlation of late between EUR and short-term rates – this outcome could weigh on EUR. That said, to the extent that the outcome is perceived as maintaining the constructive outlook for the peripheral bond markets, the EUR-negative impact of the outcome need not be pronounced.

 

2)     Larger than expected LTRO repayment could point at further upside for Eurozone short-term yields and support EUR especially against low yielding currencies like USD, JPY and to a degree GBP. Any potential gains could be contained if the repayment amount triggers renewed widening in the peripheral bond yields to Germany.

 

 

The overall impact of the LTRO announcement on EUR will also depend on the relative importance of the two drivers – the relative monetary condition in the Eurozone vis-à-vis the rest of the world and the peripheral bond yield spread. In Figure 4 we plot the sensitivity of EURUSD to changes in EUR-USD 2y rate spread and the average Spain and Italy 10y bond yield spread to Germany.

 

In particular we use t-statistics derived on the basis of regression betas from a multivariate model of EURUSD on the two drivers. The dashed lines in the chart indicate the statistical significance of the sensitivity measures - +1.64 indicating minimum level of significance for positive t-statistics and -1.64 indicating the same for negative t-statistics.

As shown, EURUSD responds positively to wider EUR-USD rate spread (positive t-statistics in Figure 4) and negatively to wider peripheral bond yield spreads (negative t-statistics in Figure 4). The results indicate that the impact of changes in the peripheral bond spreads is now more statistically significant than that of the EUR-USD rate spread.

We think that the decisive driver of the EURUSD response to the LTRO repayment could be the reaction in the peripheral bond markets to the LTRO repayment announcement. Renewed tightening in the peripheral spread in response to smaller repayment amount could help EUR withstand a potential tightening in the EUR-USD 2y rate spread. At the same time, renewed widening of the peripheral bond yield spreads in response to larger LTRO repayment amount could more than offset any positive impact from widening EUR-USD rate spread.

 

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Thu, 01/24/2013 - 16:47 | 3183648 Confundido
Confundido's picture

Banks starve for carry, not positive p&l.....

Thu, 01/24/2013 - 16:56 | 3183670 redpill
redpill's picture

 

 

 

Freaking

Out

Rabidly

Eating

Xanax

Thu, 01/24/2013 - 17:06 | 3183714 bank guy in Brussels
bank guy in Brussels's picture

In the article above they seem they feel that

« ... t-statistics derived on the basis of regression betas from a multivariate model of EURUSD on the two drivers »

is helpful for trading - ha!

Everyone has their favourite technique gambling at the casino, never tried that one

Thu, 01/24/2013 - 17:08 | 3183719 LawsofPhysics
LawsofPhysics's picture

Indeed.  I wonder what will be the currency of the Corporation of the United States of Europe?  Place your bets...

Thu, 01/24/2013 - 17:23 | 3183764 redpill
redpill's picture

One could argue it is already SDRs.

 

Thu, 01/24/2013 - 17:45 | 3183830 LawsofPhysics
LawsofPhysics's picture

A somewhat rhetorical question as the famlies behind the banking cartel in the western world have not changed in over 100 years.  Wonder how long before the famlies in the east battle the families in the west?  Going to be one hell of a party.

Thu, 01/24/2013 - 17:58 | 3183853 Stackers
Stackers's picture

You can throw all that fancy analysis out the window. The EUR is coming back down because it is getting too high above the magjic 1.30 level for German export comfort. Been saying for months that they will peg the EURUSD at 1.300 plus or minus 300bps until the market unhinges it in a BIG way one way or the other.

Thu, 01/24/2013 - 19:05 | 3184018 TruthInSunshine
TruthInSunshine's picture

There's no way that the Eurozone can be held together as a monetary union unless the € is significantly devalued vs the USD & the renminbi; it's simply not possible otherwise.

I challenge anyone to explain to me how it's possible to keep Spain & Italy as part of the EU unless the ECB is given free license to debase the € on a relative and significant basis.

I don't know what the yen and the € will do relative to each other given Japan's dilemna, but I can not see an arithmetically possible solution that allows the EU to remain a common monetary union in form remotely similar today unless the € is debased relative to the EU's two largest trading partners' currencies.

I'm not talking about a short term trade here, but a long term trend.

Thu, 01/24/2013 - 16:59 | 3183695 LongSoupLine
LongSoupLine's picture

Analysis on FX from Citi??

 

Holy Fuck, I'll take fucking dating advice from Jeffrey Dahmer first.

 

Fuck you Citi, fucking insolvent assholes.

Thu, 01/24/2013 - 17:57 | 3183859 Catflappo
Catflappo's picture

Surely the reason that banks want to 'suddenly' repay some of their LTROs is none other than rates being lower now than they were a year ago.   

Why borrow at 1% from the ECB will someone else will do it for less now?

Thu, 01/24/2013 - 18:32 | 3183956 absente reo
absente reo's picture

So tomorrow's LTRO repayment needs to be Goldilocks - too little and its clear banks have liquidity problems still; too much and the market's reaction could be notably risk-off.

 

There is no such thing as risk-off.  Not any more.  Not ever.

 

/s

Thu, 01/24/2013 - 18:42 | 3183988 Bubble
Bubble's picture

Agree reo. The mkt will ignore the unintended tightening effect and crow about how Europe is fixed. Of course if the main borrowers return the money Med bonds will be dumped as a consequence. Therefore the government program will be tightly managed and Spanish banks won't be allowed to pay back too much apart from a few token paybacks to show us all how healthy they are. The mkt will buy it all of course, so risk on until we have a non central planned event in the not too distant future.
We all know Beyonce is miming, but we all go to watch anyway.

Thu, 01/24/2013 - 21:39 | 3184427 DeadFred
DeadFred's picture

We know it's going up, Stolper told us it will hit 1.37... Oh, wait

Thu, 01/24/2013 - 20:02 | 3184187 pasmurf
pasmurf's picture

lets see if I remember ZH analysis of LTRO. If banks take it then they are seen as bad and their stock suffers.  Therefore I'm guesstimating that if the bad banks repay or lock in profits ASAP, they will be seen as good banks again,- thanks to FT Alphaville as well-

reviewing the Oct 2011 charts, from late Sept on, there is about a 10 cent up move in EURUSD move in about a month, 7 cents from Oct 4. 2011.  if there is rush to be seen as good banks to get their stock up, then another 7 cent move down in EURUSD and massive bond selloff? We'll see. 

I thought Jan 30 was the earliest pay back first day? Just announcement tomorrow?

Thu, 01/24/2013 - 23:52 | 3184761 Clowns on Acid
Clowns on Acid's picture

Excellent analysis Tyler.....but as Hillary says ..."What does it matter?"

There are no consequences anymore and if consequences rear their ugly head....more $$ are printed and MSM talking heads support the improbabilites as fact.

Consequences are for those who don't ascribe to the script or for those who just accept the script and continue lip synching along with Beyonce.

Do NOT follow this link or you will be banned from the site!