LTRO2: ECB ramps up the euro carry trade
EURUSD resilience ahead of the European Central Bank’s (ECB) second long-term refinancing operation (LTRO) was quickly put to the test, as the prospect of a fresh wave of euro-funded carry trades undermined the single currency.
The ECB revealed 800 banks asked for loans at its second LTRO, up from the 523 bidders at its first offering in December. To some that might highlight the fragility of the region’s banking system, but the increased uptake also reflects the widening of the collateral pool and the reduced stigma of making use of the facility.
Banks asked for a total of €529 billion, above average forecasts for an uptake of around €440 billion, and above the uptake of €489 billion in December.
Undoubtedly, some of the recent rally in risky assets has been down to the boost in risk appetite provided by the first round of funding.
That has also seen the EUR rally, as improved sentiment towards European banks prompted an unwinding of short positions in the single currency.
However, now with positioning - although still short -more balanced, the chances are that banks will start to put that cheap money to work outside the eurozone.
Neil Mellor, strategist at Bank of New York Mellon, says it came as no surprise on his spot desk that the euro fell on the back of the stronger-than-expected funding uptake.
“A lot of this cash will be used for speculative purposes, which of course is what the ECB is worried about,” he says.
Mellor says the liquidity is not going to solve the eurozone’s problems, particularly since the region is not in a liquidity crisis but a structural one.
“The region needs growth, and if that doesn’t materialize, the ECB is on the hook for a lot of potentially bad loans,” he says.
Mellor adds that the Sarkozy view is that a lot of the funds from the LTRO will go into the eurozone debt markets. He suspects that will be the case, but that the funds will also feed through into all sorts of other assets.
“Some of the cash will inevitably end up in euro funded carry trades,” he says.
Indeed, banks now have double the money at their disposal than they did after the last funding round.
According to the ECB, the net increase in liquidity in December – because of maturing repos elsewhere – was €192 billion. This time it is more than double that at €399 billion.
The data so far, and the ECB’s own analysis, have seen eurozone banks use the funding to bolster their own balance sheets as well as invest in government bonds, mostly on a home country basis.
The ECB’s great desire is to see the cash from the second round of funding flow back into the real economy, given that banks were able to shore up their balance sheets with the funding from the first tender.
Simon Smith, chief economist at FxPro, says the chances of this happening look to be relatively slim, given that credit demand remains weak in the eurozone – as the M3 money supply data showed this week – and banks are still aiming to reduce their balance sheets to meet upcoming capital-requirement rules.
“The chances of an external carry trade, as opposed to the internal one of the early part of 2012, look to be greater as a result,” he says.