I have to laugh when I hear some radio announcer on Bloomberg or CNBC opining about why the market went up on a given day. Today the line was something like "as stronger than expected housing starts gave 'investors' confidence that the world's largest economy will withstand the European debt crisis." GAG!
IMHO, the market rallied today off of another in a series of very well-subscribed short term Spanish auctions.
"Yields in the Spanish auction of three-month debt fell to 1.74 per cent, down from 5.11 per cent in a similar auction in November. Spain’s six-month yields dropped to 2.44 per cent from 5.23 per cent last month. Madrid also raised €5.64bn, more than allotted, in another sign of strong demand.
Market participants said the auctions were helped by Spanish banks wanting to use the paper as collateral at the European Central Bank’s loan tenders on Wednesday. The central bank is offering its first of two three-year loans, as part of its emergency liquidity programme." (FT)
As I noted before, I think this probably represents some banks loading up on government securities to use at tomorrow's ECB LTRO auction. Demand at the auction is estimated to range at between 300 and 550 billion euros. European banks have 720 billion euros of debt to roll-over in 2012, and, with capital markets frozen for many of them, the official purpose of the facility is to offer banks sufficient liquidity to allow them to resume lending and avoid asset fire sales.
However, what has the market so rabidly excited is the Sarkozy trade, in which these banks would use ECB liquidity to purchase large amounts of sovereign debt, pocketing the interest rate differential as a carry trade. In June 2009, about half of the 442 billion euros in the one year LTRO went into exactly such a trade.
How likely is this to happen again? Will it be substantial enough to make a difference given the funding needs of European governments in 2012? What could be the side effects?
According to many, this kind of fund flow into sovereign debt is less likely in this round. Reasons for this include:
How impactful? Today government bonds+loans are 7% of Spanish banks assets and 9% in Italy vs 18% in Greece. Should domestic Spanish banks increase the ratio by 1-3% in 2012, this could create €15-45bn of buying presumably at the front end of the curve. This said, there are many numerous obstacles to cross.
In a different FTAV post, SocGen gives the following assessment:
Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).
From the tone of these two notes, it certainly does not look like this would make much of a dent in the funding needs of European governments next year. To put this in further context, the reader is reminded that the ECB has already purchased 136 billion euros of Italian and Spanish debt through its Securities Markets Program. Prior to this very recent "LTRO mania," this degree of ECB intervention had done precious little to reign in yields. Furthermore, looking out over the three year term of this LTRO, the combined funding costs for Italy and Spain alone amount to 1.7 TRILLION euros! (Source: Open Europe Briefing Note 19 Dec 2011 "The Battle for the Heart and Soul of the ECB" READ IT!)
As to side effects, we've been over those. I would like to add the currency risk to foreign holders of euro area debt as another factor which could lead foreign holders (outside of EMU) of EMU debt to sell. This would further increase both the intra-country and the intra-EMU concentration risks I have alluded to before, and which Rik has expounded upon in the comments sections.
Bottom line, we shall see how this develops. My count remains as in my Quick Count post.
*Regarding duration risk, you can check out a conversation I am having regarding whether or not collateral placed with the ECB is fungible (substitutable) during the term of the LTRO in this post at SoberLook.com
IMHO, the market rallied today off of another in a series of very well-subscribed short term Spanish auctions.
"Yields in the Spanish auction of three-month debt fell to 1.74 per cent, down from 5.11 per cent in a similar auction in November. Spain’s six-month yields dropped to 2.44 per cent from 5.23 per cent last month. Madrid also raised €5.64bn, more than allotted, in another sign of strong demand.
Market participants said the auctions were helped by Spanish banks wanting to use the paper as collateral at the European Central Bank’s loan tenders on Wednesday. The central bank is offering its first of two three-year loans, as part of its emergency liquidity programme." (FT)
As I noted before, I think this probably represents some banks loading up on government securities to use at tomorrow's ECB LTRO auction. Demand at the auction is estimated to range at between 300 and 550 billion euros. European banks have 720 billion euros of debt to roll-over in 2012, and, with capital markets frozen for many of them, the official purpose of the facility is to offer banks sufficient liquidity to allow them to resume lending and avoid asset fire sales.
However, what has the market so rabidly excited is the Sarkozy trade, in which these banks would use ECB liquidity to purchase large amounts of sovereign debt, pocketing the interest rate differential as a carry trade. In June 2009, about half of the 442 billion euros in the one year LTRO went into exactly such a trade.
How likely is this to happen again? Will it be substantial enough to make a difference given the funding needs of European governments in 2012? What could be the side effects?
According to many, this kind of fund flow into sovereign debt is less likely in this round. Reasons for this include:
- Leverage issues, especially in the light of EBA
sham"stress" tests. - Bank funding issues, as mentioned above.
- Cost of hedging via CDS market is much higher now versus 2009.
- Confidence in effectiveness of CDS hedges is much lower now, given the efforts to avoid a triggering event in the Greek debacle.
- Exposure to collateral calls. Throughout the term of this three year facility, the ECB will mark-to-market bonds held as collateral. If bond values falter, banks could have to pony up additional collateral to the ECB. This may exacerbate their own funding issues.
- Interest rate risk. Loan rates are subject to change if the ECB's benchmark fund rates increases during the three year term. Unlike the FED, the ECB has not pledged to keep rates at the current 1% for a specific period.
- Shareholder Perceptions (aka Stigma): This time around, there is a prevailing sense of over-exposure to sovereign debt, and a greatly diminished perception of its safety. Banks may not want to be seen as piling into more of it. There may also be a hesitancy, especially among larger banks, to not be seen as being too dependent on Central bank funding.
- Bondholder Perceptions: To quote from an RBC note, "the more a bank uses up ECB liquidity and other forms of collateralized funding, the more the senior unsecured becomes subordinated in the liabilities structure."
- Duration Risk*: Apparently, (this is not certain) ECB rules require that the collateral offered not expire during the term of the loan. I believe that banks will have the option to unwind the trade one year into it, so this could mitigate these risks to some degree by allowing the pledging of shorter term bonds. As an aside, this brings up the question of a possible large spread developing between the long and short end of the European sovereign debt market, with governments only able to affordably fund themselves short term. An effective transition to shorter term funding is NOT what Europe needs at this time, and would raise the obvious question as to how the ECB would ever be able to unwind this LTRO facility.
How impactful? Today government bonds+loans are 7% of Spanish banks assets and 9% in Italy vs 18% in Greece. Should domestic Spanish banks increase the ratio by 1-3% in 2012, this could create €15-45bn of buying presumably at the front end of the curve. This said, there are many numerous obstacles to cross.
In a different FTAV post, SocGen gives the following assessment:
Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).
From the tone of these two notes, it certainly does not look like this would make much of a dent in the funding needs of European governments next year. To put this in further context, the reader is reminded that the ECB has already purchased 136 billion euros of Italian and Spanish debt through its Securities Markets Program. Prior to this very recent "LTRO mania," this degree of ECB intervention had done precious little to reign in yields. Furthermore, looking out over the three year term of this LTRO, the combined funding costs for Italy and Spain alone amount to 1.7 TRILLION euros! (Source: Open Europe Briefing Note 19 Dec 2011 "The Battle for the Heart and Soul of the ECB" READ IT!)
As to side effects, we've been over those. I would like to add the currency risk to foreign holders of euro area debt as another factor which could lead foreign holders (outside of EMU) of EMU debt to sell. This would further increase both the intra-country and the intra-EMU concentration risks I have alluded to before, and which Rik has expounded upon in the comments sections.
Bottom line, we shall see how this develops. My count remains as in my Quick Count post.
*Regarding duration risk, you can check out a conversation I am having regarding whether or not collateral placed with the ECB is fungible (substitutable) during the term of the LTRO in this post at SoberLook.com
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