Over the past month, much has been said about the recent 3 year LTRO, and its function in stabilizing the European bond market. Certainly it has succeeded in causing an unprecedented steepening in European sovereign 2s10s curves across the periphery (well, except for Greece, and recently, Portugal) as by implication the ECB has made it clear that debt with a sub-3 year maturity is virtually risk free, inasmuch at least as the ECB is a credible central bank (and if it is perceived as no longer being one, there will be far bigger issues), along the lines of what the Fed's promise to keep ZIRP through the end of 2013, and today's likely extension announcement through 2014. Yet does filling a much needed for European stability fixed income "black hole" equate to a catalyst for Risk On? Hardly, because as in a new note today Brockhouse Cooper analysts Pierre Lapointe and Alex Bellefleur explains, the LTRO is "not a catalyst for a risk-on rally as the central bank is substituting itself for funding sources that have “dried up.” Sure enough - all the ECB is doing is preserving existing leverage (especially in light of ongoing bank deleveraging), not providing incremental debt, something which could only be done in the context of unsterilized bond monetization ala QE in the US. So just over a month in, what does the LTRO really mean for Europe (especially as we approach the next 3 Year LTRO issuance on February 29)? Here is Brockhouse's explanation.
- The 3-yr LTRO is not a catalyst for a risk-on rally as the central bank is substituting itself for funding sources that have “dried up"
- "This is a key difference that implies that the current collateral shortage will continue"
- Collateral shortage negative for velocity of collateral, velocity of money, “not exactly a catalyst for a rally"
- Not all LTRO funding is “parked” in short-term peripheral debt as ECB overnight lending touched record EU528b Jan. 17
- "The stigma associated with borrowing from the ECB is visibly gone, but the stigma associated with holding peripheral debt remains present"
- Post-LTRO, developments in peripheral sovereign bond markets are driven more by solvency factors than liquidity factors
- "The desire to de-risk European bank balance sheets will continue to prevail and the need for higher capital requirements will continue to constrain leverage"
And that's the main difference between the European "easing" and that of the Fed: in Europe the ECB's balance sheet is merely filling the leverage void created by the recent mauling of European banks and the fact that nearly €500 billion is still parked with the ECB: hardly an indicator of confidence in the system. In the US, QE1 and QE2, were not only substantial, they provided incremental liquidity into the system, which then spilled over into risk assets.
The question the becomes: what happens to the capital lent out at the next LTRO? Unfortunately, as the bulk of it will go to prop up European bank capital in anticipation of a Greek, and potentially Portuguese - its 10 year just hit a new record, default (controlled or otherwise), it is more than likely that while the market may front run it once again, the final outcome will be even more frozen cash which does nothing to actually benefit from the carry trade, or to pump risk assets.
The bottom line is that with an ECB constrained from unsterilized monetary intervention, any and all generous liquidity injections will have to come from the Fed. Which, however, will likely not be in a position to do much if anything today courtesy of a market which has front run itself precisely expecting this event, as well as believing, falsely as it turns out, that the massive ECB balance sheet expansion was actually beneficial for Risk On, when all it has succeeded in doing is mitigating the Risk Off phase.