Is Japan’s ‘happy depression’ about to turn unhappy?
February 23, 2012
There is nothing like a shot of liquidity to set the market's pulse racing. The first European Central Bank offer of cheap, unlimited three-year loans to banks pumped €198 billion ($262.3 billion) of new money into the economy net of funds used to roll over existing ECB facilities—enough to fuel a substantial rally across asset classes.
But as with any artificially induced high, the euphoria is liable to wear off unless the dosage is increased. On that basis, next weekend's second Long-Term Refinancing Operation risks being a disappointment.
Estimates of what banks might borrow vary from another €200 billion of net new money up to €1 trillion. The size of the range reflects uncertainty over what banks will do with the funds. Some banks will have no option but to take ECB loans to finance existing lending since they are cut off from other sources of funding.
Peripheral country banks clearly fall into this category. Italian and Spanish banks used the first LTRO to take care of their funding needs until the second half of this year and may use the second to secure their funding until well into 2013. Some French and Austrian banks may also need funds for these purposes, judging by the decision to ease local collateral requirements.
But banks may be wary of using the LTRO to fund ordinary lending if they can avoid it, no matter how cheap, since the loans must be repaid after three years. That is less than the maturity of a typical corporate loan, let alone a mortgage. The LTRO also requires collateral at a time when banks are already heavily reliant on other forms of secured funding, such as covered bonds. A shortage of unencumbered assets could restrict future access to senior unsecured bond markets. That is why banks such as UniCredit have raised money in private markets even when the cost is well above the LTRO.
The big uncertainty is whether some banks will use the LTRO to fund carry trades, borrowing cheap ECB money to buy higher-yielding sovereign bonds. Spanish banks appear to be doing this already: Madrid has already raised 35% of this year's funding needs, but 65% of issuance has had maturities under five years, compared with less than 35% in normal years, according to Morgan Stanley. That points to heavy buying by banks.
Italy, in contrast, has so far raised just 10% of this year's target, suggesting limited carry trades. What seems certain is that there is limited appetite for cross-border carry trades.
That may point to an LTRO take-up closer to the bottom of the range, similar in size to the last one. That could disappoint those counting on another liquidity rush to support sovereign yields and slow the pace of deleveraging. On the other hand, it could also signal a shrewd awareness of the need to avoid a longer-term destructive addiction.