Citigroup Analyzes The Failure Of The LTRO, Muses On The Upcoming French Downgrade

Now that the LTRO flop has been digested, one of the more curious explanations for the failure comes from Citi's Steven Englander, who suggests that, surprise, surprise, Italian banks were lying yesterday when they said that they were ready and willing to buy Italian debt with LTRO proceeds. To wit: " One dose of cold water were comments from the Italian Bank Association that EBA rules won’t permit Italian banks to buy sovereign debt – this is a complete reversal from reports yesterday that indicated that Italian bank collateral would benefit from government guarantees in going to the ECB and lead to incremental  Italian bank buying of sovereign debt." Gee: someone lying? NAR who could possibly conceive of that... And more to the point, Englander has an interesting observations on the market reaction to the upcoming French downgrade: "the S&P downgrade of euro zone sovereigns is hanging over the market but there is no definite timing – every day brings one rumor or another of an imminent moves. More concretely there is a chorus of French and euro zone officials managing expectations downward. S&P probably wants to manage the announcement so as to have the least market impact, but it is unclear whether that means doing it when most investors are inactive but liquidity is low or the opposite. At this point a French downgrade is no surprise. A one-step downgrade would be a positive surprise, but downgrading core-core Europe – Germany, the Netherlands, Finland – would still be a negative. Today’s LTRO may be a (reverse) template for the reaction to a downgrade: kneejerk selling followed by a rebound." Well, only one way to know for sure what happens post the downgrade - bring it on.

From Citigroup:

The LTRO was greeted with initial enthusiasm by markets but then fizzled out. The EUR is down small so far on the day, a reversal from its big gains in the immediate aftermath of the LTRO announcement, taking other European currencies (GBP excluded) with it. The EUR 489bn was in the EUR400-500bn range that our economists were expecting but somewhat stronger than published consensus that was more in EUR300-400bn.  That said, the fat tail was clearly to the right and there were indications that many expected a much larger number than the consensus.

The next question is what is done with the money. The Summit has had a fair amount of bad press and euro zone policymakers wanted to show that substantive progress had been made. Hence comments from Draghi over the weekend and other euro zone officials could be seen as encouraging a strong take-up. Whether the money will be used to buy sovereign debt (the secret wish), or be lend out to businesses (the stated wish) is unclear. There is plenty of liquidity in the system not doing much of anything, so the auctions at the beginning of 2012 will be scrutinized carefully to see if the carry trade is being reignited.

We would still interpret the initial move as driven by short covering. Our CitiFX Access indices of FX returns shows that investors as a group made money last week when risk-correlated currencies were selling off, and have it this Monday-Tuesday week as risk appetite rebounded. To be clear overall positioning is modest, but the biggest positions appear to be with CTAs who are relative quick to exit positions that are moving in the wrong direction. Hence even when the euro was being bought, it was as  a short squeeze in an illiquid market, rather than a wave of two-fisted buying. Some argue that the euro sell-off was driven by investors who had gone long on LTRO fever, but none of the indicators we look at show significant euro longs in the market.

The remaining mystery is why the sell-off is so severe.  One dose of cold water were comments from the Italian Bank Association that EBA rules won’t permit Italian banks to buy sovereign debt – this is a complete reversal from reports yesterday that indicated that Italian bank collateral would benefit from government guarantees in going to the ECB and lead to incremental  Italian bank buying of sovereign debt.  We still consider the LTRO outcome to have been a moderate success, if only because the ECB balance sheet exposure suggests that they will be much happier with a debt crisis resolution than with a disaster, but in illiquid markets the noise to signal ration is extremely high.

We see the swings as being liquidity determined, exaggerating both the response to the buying/short covering in the immediate aftermath of the auction and similarly amplifying any selling.  The LTRO is the last 2011 ‘event’ calendared in the market and both 2011 winners and losers are probably closing books.

That said, the S&P downgrade of euro zone sovereigns is hanging over the market but there is no definite timing – every day brings one rumor or another of an imminent moves. More concretely there is a chorus of French and euro zone officials managing expectations downward. S&P probably wants to manage the announcement so as to have the least market impact, but it is unclear whether that means doing it when most investors are inactive but liquidity is low or the opposite. At this point a French downgrade is no surprise. A one-step downgrade would be a positive surprise, but downgrading core-core Europe – Germany, the Netherlands, Finland – would still be a negative. Today’s LTRO may be a (reverse) template for the reaction to a downgrade: kneejerk selling followed by a rebound.