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:
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Perhaps more striking is this chart, which shows rising proportions of sovereign securities to total assets in the banks of peripheral countries that have been most prone to interest rate shocks over the last few years:
[25]
Sure, it might seem counterintuitive to gobble up the very sovereign debt representing such an existential threat to one's own capital base, but when one examines the effects that the LTROs have had on eurozone sovereign yields, it seems reasonable to assume that is the ECB's plan and we will just have to live with it. As Citi puts it:
As the EBA announced in February, that the next stress test will be in 2013, periphery country banks have the blessing of European regulators (and probably the active encouragement of their national regulators and other national authorities) to expand their holdings of domestic securities, and specifically domestic sovereign debt.
Jefferies chimes in Sunday evening with a brief history of modern financial repression, following on the same threads that Dylan Grice [26] and Credit Suisse strategists [27] explored last week. Did you know, for example, that between 1945 and 1980, there was only a single year when Argentina saw anything other than negative real interest rates? Jefferies summarizes a piece of academic research put out by the Bank for International Settlements in November 2011:
It appears that individuals forget that financial repression has been used far more frequently in the past, particularly in liquidating the vast debt accumulated by developed countries post the Second World War. Indeed, in the past, the US and UK have seen their debt ‘liquidated’ using negative real interest rates by 2% to 3% of GDP on average per annum. The US and UK did not use high levels of inflation to do so in comparison to other countries. Argentina holds the record with negative real interest rates recorded every single year but one between 1945 and 1980.
Secondly, the inflation rate may not necessarily need to neither be that high relative to history nor take markets by surprise. According to the authors, between 1945 and 1980, the average US and UK negative real interest rate was 3.5%. However, the average for Argentina between 1942 and 1980 was 21.4%.
What should be recognized here is that, irrespective of one's opinion on inflation prospects, one ought to consider the possibility that, if a central banker believes it can be done, a central banker will probably try to do it -- in fact, the decision might even be credibly backed by a study done by none other than the central bank of central banks, the BIS.
Here is what the process has typically looked like the past:
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So, with the negative real-rate outlook as a backdrop, Jefferies finds the proper words to elucidate its views on last week's LTRO:
The ECB’s LTRO can be thought of as ‘a shadow QE’, in which the domestic banks support the ‘financial repression’ of their respective government debt. In effect, they have doubled down on their own government debt to rescue the country and at the same time themselves. Low nominal yields keep the governments solvent while the banks can earn a healthy spread between borrowing at 1% and owning government debt at more than triple that over a three year period. The scheme can work as long as the government does not default.
Morgan Stanley is running with the same theme on Sunday with a brief remark on LTRO, echoing the comments above:
With banks incentivised by the cheap loans and encouraged by their regulators and governments to load up on the bonds of their sovereigns again, they are actually becoming more vulnerable to the next sovereign crisis. Recall that the ECB’s version of QE, which we call indirect QE, differs from other central banks’ QE in an important way: there is no transfer of sovereign risk from the private sector to the central bank. Rather, the risk remains on banks’ balance sheets.
As noted earlier, the elevated dispersion in LIBOR rates [29] could be indicative of data that doesn't jibe with the official story on post-LTRO sentiment in the European financial system. Soc Gen, however, thinks LTRO has provided more than enough liquidity to address funding stress:
The result from this exercise, which is more important than the actual number, is the fact that banks have taken up as much funds they believe they need. And that should ease any concerns about funding (banks face €320bn of redemptions in senior unsecured and government guaranteed bonds this year) or liquidity issues. Furthermore, it is likely that banks will look to use the funds for carry trades and the front-end financials look likely to benefit as was the case in December/January.
Indeed, there is a lot of buzz over the potential for carry profit the ECB has introduced with their LTRO programs. Here's a great example of a winning carry trade, courtesy of Citi:
Individual bank reports suggest that non-euro banking groups too used their euro area branches to tap the 3Y LTRO in February more than they did in December. If there was a large demand by foreign banking groups, and if the liquidity obtained in the LTROs by their euro area subsidiaries was channeled outside the euro area (and possibly swapped into other currencies), this would clearly undermine the stimulus of the 3Y LTRO for euro area companies and households.
However, the LTRO does not address any solvency issues or how much credit will flow into the economy as banks are still likely to reduce their balance sheets given the mediocre economic outlook.
Clearly -- but clearly, this isn't about "companies and households," unless by companies one means banks. Jefferies provides a perfect visual representation of the bottom-line effect an extra €1 trillion's worth of liquidity is having on markets. Not that it isn't already abundantly clear what happens as of late when a) central banks decide to open the pipes and b) try to stem the flow coming out of the fire hydrant, but this should drive it home:
[30]
LTRO has also been driving an impressive rally in euro credit markets, especially in new supply, which is booming. Soc Gen:
€35bn of non-financials issuance and almost €45bn in senior unsecured have made the opening salvo in the primary market quite fantastic. Almost every issue printed this year is trading tighter versus reoffer as the initial LTRO-fuelled rally works its magic and has the desired impact of boosting credit markets. Tighter spreads, lower new issue premiums and great demand have combined to keep interest at a high. Issuers are seeing lower funding costs and investors have their performance.
The going right now is so good, issuers should be striking while the iron is hot. High beta core premiums are now in single digit territory and we could expect peripheral corporate premiums to follow suit in due course.
Looks like the only losers here are the vulture types, who according to Goldman are concerned about "LTRO 2 potentially slowing distressed asset sales in Europe." Major bummer, but who knows -- they may find another buying opportunity coming their way at some point.
For those who especially appreciate well-placed double entendre in their sell-side research, Citi now believes it prescient -- based on more deductive reasoning on LTRO -- to divide the non-periphery eurozone countries into a "soft core" group and a "hard core" group (really):
Data from the Netherlands, where banks have increased their take-up from the ECB by more than 4 times between June and December 2011, confirms our view that the country has moved to the group of soft-core countries. In our view the only hard core countries are Germany, Luxembourg and Finland.
A final word from the Jefferies note on the shell game the ECB has been able to pull off with regard to collateral standards:
Investors should keep an eye on shifts in collateral since the injection of liquidity has been done against very lenient collateral standards. Although the ECB could easily engage in further LTRO tenders, in our opinion it would not be in the ECB’s interest to continue to adopt a laissez- faire policy towards the collateral it accepts. One way for the central bank to keep the LTRO in place but reduce its systematic risk would be to tighten collateral standards. This would be a modest ‘risk off’ bet for markets but might not get noticed initially.
Filling your head with euro dreams... @dailycollateral [31]