"Only A Serious Economic Shock": ECB Said To Consider New T-LTRO; Euro Tumbles

2012 was a seminal year for Europe and the ECB: that was the year when tensions in Euro markets receded in the second half of 2012, following Mr. Draghi's seminal "whatever it takes" intervention in July of that year. The resulting containment of re-denomination risk in the Euro area and the wider improvement in market sentiment that followed helped re-establish a basis for better functioning of private markets. As a result, the need for central bank intermediation of intra-Euro area cross-border financial flows diminished.

But just as importantly, that was also the year when the ECB's balance sheet had peaked shortly after the first 3-year Longer-Term Refinancing Operation (LTRO) was conducted...

... and whose runoff resulted in a major shrinkage in the ECB's balance sheet, ultimately forcing Mario Draghi to launch QE as yields blew out.

Fast forward to today, when it is "deja vu" all over again for the ECB's T(argeted)-LTRO.

But first, some background: At his press conference following the October 25 Governing Council meeting, ECB President Mario Draghi mentioned that "the TLTRO was raised by two speakers ... but not in any detail". And subsequently in a speech given in Paris, Banque de France Governor François Villeroy de Galhau remarked that "the question of TLTROs will need to be considered".

Apparently, the targeted long-term refinancing operations (T-LTROs) initiated by the ECB in mid-2014 are coming back into policymakers' focus, as one of the range of policy instruments available to manage the evolution of Euro area monetary policy.

Part of this renewed focus results from the first wave of 4-year T-LTROs starting to run off the ECB's balance sheet. The first such operation was conducted in June 2014. The second was announced in March 2016. And, as Goldman points out in a recent note, to the extent that these operations maturing is associated with better market access for banks that had funded through the T-LTROs, this is a healthy sign of the re-booting of the credit system following the travails of the crisis years.

However, policymakers revisiting T-LTROs may also be a symptom of less benign developments. In particular, it may be symptomatic of the funding situation of banks that remain reliant on ECB operations to finance their balance sheets.

And, with the Italian sovereign debt/bank crisis once again on the radar at a time when the central bank is about to end its QE, any suggestion that the ECB will soon experience a period of significant balance sheet shrinkage will likely be met with even more dread by the market.

Here is the problem in a nutshell: Euro-area lenders are facing a cliff edge for their funding, and, as Bloomberg notes, some are hoping the European Central Bank will help them out. Around €722 billion ($832 billion) of long-term loans granted to banks by the ECB will start maturing from 2020, and new regulatory standards mean replacement funds could be needed as soon as next year. Adding to the concerns of balance sheet reducation is that lenders could be forced to refinance just as market rates rise, spurred by tighter U.S. policy and tensions such as Brexit and Italian politics.

As a result, some banks have been in contact with the ECB to discuss the risk of letting those four-year loans expire without affordable alternatives being in place, Bloomberg sources report, with some discussions taking place on the sidelines of the International Monetary Fund meeting in Bali this month.

And now, according to MarketNews, the ECB has responded to these concerns and is indeed considering a fresh T-LTRO.

That the ECB is considering this, or merely "trial ballooning" the concept, suggests that the ECB is getting nervous about a confluence of events, one of which is the sharp slowdown in the Eurozone economy, which just printed the lowest GDP in 4 years...

...even as the standoff between Rome and Brussels over Italy's deficit continues with zero progress, resulting in sporadic episodes of bond market turbulence and threatening not only Italian sovereign bonds, but also Italian banks (due to the doom loop), and by implication, contagion into the broader Eurozone.

According to MNI, a new T-LTRO could be discussed as soon as December, but notes that "only a serious economic shock could prompt the move."

Of course, since nothing has been fixed in the Eurozone, the ECB will have no choice but launch a new T-LTRO, one which merely allows existing debt to be rolled over, however by doing so it would confirm that the Eurozone has, in fact, triggered an "economic shock."

Which is why it is no surprise why the Euro tumbled to session lows on the news...

... sent the dollar to highs, and pushed yields higher now that the sequence of events at the ECB appears to be T-LTRO first, and only then more QE, confounding those analysts who expected Draghi to give up on his plan to end QE and continue monetizing Eurozone debt.

In any case, and as is customary for the ECB, watch for a round of denials in the near-term, followed by another trial balloon to gauge the market reaction, before Draghi ultimately commits to a new, and massive T-LTRO some time around the turn of the new year.

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For those interested in more, here are some additional observations from Goldman on the touchy issue of T-LTROs, and their return to Europe:

Bank reliance on T-LTROs. Reflecting their relative difficulty in accessing private funding markets, Italian banks were large subscribers to the 4-year T-LTROs offered by the ECB.

Admittedly, thus far we have not seen a re-emergence of bank funding tensions as the initial round of T-LTROs starts to mature. But banks were able to roll their recourse to the first wave of T-LTROs into the second wave (which started in June 2016) if they chose to do so. As a result, the maturing of the first wave has not proved to be a binding constraint for the funding of T-LTRO-dependent banks.

The second wave of T-LTROs was announced in March 2016 with the first tender in June 2016, so that they will only start to run off the Eurosystem balance sheet in mid-2020. This may still appear some time away. Yet the implementation of the new Basle liquidity rules – specifically, the net stable funding ratio (NSFR) rule – brings forward the impact of a prospective end to T-LROs.

In essence, the NSFR requires a certain proportion of bank funding to have residual maturity of at least one year. By implication, the 4-year T-LTROs implemented in the second wave of operations starting in June 2016 will cease to support this ratio from the middle of next year. This is likely to imply a squeeze on T-LTRO-dependent banks, with Italian regional banks to the fore.

While there is little appetite for introducing specific measures to address Italian market tensions – with Mr. Draghi repeatedly emphasising that ECB policy is governed by an area-wide perspective, and cannot be oriented to the specific needs of an individual country or region – the political hurdle to another wave of T-LTROs appears lower. T-LTROs are now firmly established as part of the ECB's policy toolkit. This may explain why policymakers have singled out T-LTROs in recent communication.

Political economy of rolling T-LTROs. Against this background, policy choices regarding a new wave of T-LTROs can play an important role in shaping the environment facing Italy and Italian banks.

On the one hand, allowing funding tensions on Italian regional banks to build by withholding reassurance that T-LTRO funding will be renewed is a powerful lever by which the European authorities can influence the market pressure on the Italian government to change its fiscal trajectory.

On the other hand, allowing funding tensions in T-LTRO-dependent banks to become excessive or systemic could threaten broader instability across the European financial sector. In that case, not only would pressure on the Italian government be dissipated as the impact became less surgically targeted, but other more malign vulnerabilities could resurface.

The sensitive task facing the Governing Council over the coming months is how to manage the difficult trade-off between these two dynamics.

The way forward. With (i) the Italian government facing higher borrowing costs, (ii) the regulatory environment for government bank bailouts more complex since the implementation of the EC's new bank recovery and resolution directive (BRRD), and (iii) the willingness of the Italian government to accept the conditionality implicit in an ESM bank support programme (akin to that implemented in Spain at the peak of the crisis) uncertain, we see further T-LTROs as likely.

For still weak Italian regional banks that hold Italian sovereign debt on their balance sheet, the recent and prospective market environment is likely to increase their dependency on T-LTROs.

Rather than a monetary policy or liquidity impact, such T-LTROs would essentially provide a funding backstop to contain risks to financial stability. But such actions can be justified – as in the past – as measures to preserve the transmission of monetary policy across the Euro area. The legal basis for such measures has been established.

The terms of any new T-LTROs are likely to be less favourable than for previous waves. In particular, with the ECB continuing to signal the likelihood of policy rate hikes in late 2019, which may get pushed out to 2020H1 (at least on our reading), the scope to conduct a 4-year operation on a fixed rate basis (as is currently the case for the T-LTROs) is limited. A shorter maturity and a rate indexed to the policy rate would be possible innovations. This would imply that there is less of a policy signal in the T-LTROs and that these should not be seen as part of the ECB's forward guidance. They would also not be used, as was the case in the past, as a way to increase the ECB's balance sheet. In this sense, the T-LTROs become more of a 'micro' rather than 'macro' tool to deal with specific funding issues for certain banks and keep the transmission mechanism of its monetary policy to Italy intact.

At the same time, we do not expect the Governing Council to announce further T-LTROs in the very near term, i.e., the coming few months, as the funding pressure on T-LTRO-dependent Italian banks remains a powerful lever to pressure the Italian government towards a fiscal stance that is more compliant with EU rules.