The long-term refinancing operation (LTRO) is meant to bring down interest rates and repair some might say replace the transmission mechanism of the banking system, as it passes that benefit to the real economy.
What happens now?
Most market strategists suggest that the European Central Bank (ECB) must pause and assess the effectiveness of the extraordinary measures it has taken, perhaps keeping some powder dry for a third injection only if signs emerge of a imminent financial system crash bringing renewed threat of deflation.
Credit Suisse analysts, in a report titled ECB Its Raining uros, suggest:
We believe that the ECB will end up doing more proxy QE in the future (via LTROs), especially if the euro strengthens further. We believe that the ECB is potentially more dovish than the market realises (not least because they own and repo nearly 900 billion of peripheral European debt and there is some evidence that the core are now being outvoted by the periphery on the ECB Governing Council).
The Swiss bank suggests that, for markets, the second LTRO should support lower rates, emerging-market and higher-yielding G10 currencies and also equities.
They say that excess liquidity is consistent with a 4% re-rating of equities; the equity risk premium is 6.2%, some one percentage point above warranted levels on our models; equities remain the cheap inflation hedge, as central banks move towards more synchronised QE; positioning is still much more cautious than sentiment; and there remains substantial upside risk to our year-end target of 1400 on the S&P 500.
It is no wonder that German policymakers remain suspicious.
By propping up weak government finances at one remove, by lending to the banks that in turn buy government bonds, the ECB is playing a clever game. It is abiding by the letter of treaty prohibitions of financing governments. Sometimes it takes an outsider to spot the obvious.
At a recent speech in London, former Federal Reserve governor Randall S Kroszner, who worked beside Ben Bernanke on the Feds own adoption of extraordinary measures between 2006 and 2009 and is now professor of economics at the University of Chicago Booth School of Business, pointed out: The ECB has shown itself to be the only fiscal agent for the eurozone capable of sharing profits and losses among member states.
For their part, the Credit Suisse analysts agree that the ECB is mutualizing eurozone debt partly because the haircuts on much of the collateral being posted are at below market rate for the associated risk.
The beauty of the LTRO is that: the German public opinion does not understand it; the ECB can claim that adequate collateral is being posted; and the still high level of 10-year BTPs and Bonos forces Italy and Spain to continue reforming.