ECB Preparing To Close Liquidity Spigot?
With the hopes and dreams of every long-only manager and beta-chaser now resting on the broad shoulders of nominal-wealth-creators at the European Central Bank and its LTRO 2 offering, today's news from Reuters that 'powerful members of the ECB's council are privately hoping demand will fall well short of the EUR1tn that many expect' confirms their hope that it will be the last. Critically, as we have discussed before, markets are becoming used to the pump and will expect endless LTRO (especially given the moves in bank stock prices - while credit has underperformed significantly in the last week or two) and central bank sources tell Reuters 'they are worried that banks will become too reliant on ECB funds'. This is exactly the unintended consequence we warned about as the banks will become less incentivized to lend and create credit to drive the real economy (even as the nominal economy - or equity market) surges. The implicitly hawkish stance increasingly being taken by the ECB as Weidmann warns of the 'too generous' supply of cheap/free-money should prompt concerns that the ECB will close the liquidity spigot sooner than consensus hopes and as is evident from last April/May's tightening and the exuberant expectations priced into stocks for more printing, perhaps credit's recent weakness signals that asset prices are overdone here (especially as there is no sign of credit creation in the real economy and ECB reserves continue to rise).
The last time the ECB began to tighten, stocks dropped dramatically...
but the growth of the ECB balance sheet has driven stocks in Europe much more directly.
Two things of note in this chart:
1) The plunge in stocks as the US was downgraded and European chaos increased was too large for even the ECB's balance sheet growth to stop (this is noteworthy as sometimes the Central Bank Put just isn't struck at the right level or simply has too little delta) - even though the expansion off the lows did indeed prime the pump for stability and then as we were told of LTRO 1, markets accelerated to that new expectation; and
2) The last month or two (post LTRO1) as the ECB balance sheet has slowly leaked lower was ignored by the equity market (orange oval) as expectations of LTRO 2 were increasingly priced in.
Given the expectations priced into stocks (and remember credit has rallied but has recently started to weaken notably), any more hints by the ECB that LTRO 2 will be the last and that the liquidity spout is being shut down for now - leaving governments more responsible for growth - will not be taken well by the market.
As an aside, regarding the LTRO and its 'flaw' that we have discussed at length, perhaps today's increasing stigma (lower pane) once again stymies some demand from 'good' banks for ECB funds. We continue to track this 'stigma' trade for insight into LTRO 2 size expectations.
The European Central Bank wants its second offer of cheap ultra-long funds next week to be its last, putting the onus back on governments to secure the euro zone's longer-term future.
Powerful members of the central bank's 23-man governing council are privately hoping demand at the February 29 auction will fall well short of the 1 trillion euros some expect, backing their view that it should be the last.
Central bank sources say they are worried that banks will become too reliant on ECB funds, removing the incentive to restart lending between themselves.
ECB officials accept they have to help the banking sector but they also want to send a message that the unprecedented liquidity provision will end.
Bundesbank chief Jens Weidmann has warned that "too generous" supply of liquidity could create risky incentives for banks, which could in turn store up future inflation risks.
Bank of Finland chief Erkki Liikanen is also worried about ample liquidity provision leading to future problems and has said the ECB must think about how to unwind the extraordinary measures. Other senior policymakers are concerned too.
The ECB is also concerned the interbank market is not yet functioning fully. Bankers themselves see this concern.
"If you are flooding the market with cheap refinancing then there comes a point when you are preventing the market from working because nobody is going to borrow from another bank at X percent if they can borrow from the ECB at Y percent," said a senior banker at a leading global bank.
The ECB expects governments to take responsibility for banks that prove too weak to help with extra liquidity and believes states should step in if, in three years when the funding term comes to an end, they are incapable of repaying the credit.
This may come as something of a shock to some banks and officials. One senior EU official said he had expected the ECB would offer banks a third round of long-term funding.
"We expected a third," he said. "They (ECB) have always said they will keep an eye on how the market is evolving. My guess is that they are hedging their bets."