LTRO Version 0.2

LTRO version 1.0 continues to capture the markets attention.  It was a reason to rally, then fade, now back to an excuse to rally.

My contention all along has been that LTRO was good for banks.  It dramatically reduced the liquidity risk for banks. It did nothing for the solvency of banks or sovereigns, and I continue to believe it doesn’t do anything for the liquidity risk of sovereigns. I think the belief that the carry trade is at work is a fallacy.

Yes, Spain and Italy are doing better, but that has as much to do with some pent-up demand, some not too subtle encouragement to roll debt, and a lot of shorts being caught offsides to the start of the year rally.  The LTRO carry trade has little direct evidence of being at play.  Banks do buy sovereign debt and had debt maturing over the past quarter, so it is not surprising they might buy some more.  The ECB continues to attract huge deposits which is an indicator that the LTRO carry trade is not being employed as widely as many people would like or hope.

Italy in particular has a weird dynamic the market is still trying to digest.  Italy guaranteed bonds so that banks could get ECB money, allegedly to buy Italian bonds.  In an attempt to be more “family friendly” I will go all Disney on you and call this the “circle of life” trade rather than a ponzi scheme, but in the end, the banks and countries are becoming one and the same in the weakest countries.

We will soon find out whether the next tranche of LTRO is version 2.0 or version 0.2.  I have read some articles where people are hopeful that the next tranche will be at least 500 billion and could be as much as a trillion.  I expect full disappointment for that crowd.  I believe the next tranche of LTRO will actually be smaller than the first tranche!

I believe the banks accessed LTRO for 2 important reasons.  One, they wanted to consolidate a bunch of borrowing they had from the ECB via a hodgepodge of other lending programs (“emergency” and otherwise).  They also wanted to prefund their debt maturities for the year.  They know there is minimal demand from short-term bond investors (or long-term ones) so they wanted to ensure they borrowed enough via LTRO to be able to pay off all their debt coming due this year.  They did NOT take down LTRO to buy new assets and are still in deleveraging mode, so will NOT use the next LTRO offering to take on new money.

Banks are deleveraging.  LTRO is making it easier for banks to manage their near term liquidity risk.  That has helped ease pressure but has not turned banks into “risk on” mode.  We will see what happens but I believe that the second tranche of LTRO will be a pale comparison of the first in terms of size which will damage market excitement over how much of the “carry” trade is going on.