It’s baaack! The prospect of eurozone banks buying more sovereign debt to take advantage of new cheap one-year ECB liquidity, that is.
You’ll have heard that the ECB will offer not one but two one-year Long-term refinancing operations to banks before the end of 2011, following October’s meeting.
Supposedly this is to address funding pressures related to sovereign exposures. Although as ever, there’s an incentive for banks to earn carry off the LTRO by grabbing hold of peripheral sovereign assets which yield more than its fixed rate and which mature before it ends.
Even before the LTRO announcement, Nomura rates analysts writing on Wednesday were already thinking of specific sovereign bonds that meet these criteria (and therefore to go long on them in anticipation of bank demand). As Laurent Bilke and Guy Mandy note, two names pop up:
The composition of the basket is very different today from 2009. If we consider short-dated bonds yielding more than the ECB‟s main rate, in 2009 this set included a more diverse range of sovereign bonds. It would now be limited to Italian and Spanish government bonds, nominals and linkers if we exclude the three countries that are currently being bailed out (see Figure 4 for a list of bonds in our basket, nominal yields, outstanding).
The ECB carry trade on the eligible Italian and Spanish government bonds would therefore leave them exposed to significant marked-to-market fluctuations. It is technically possible to hedge against this, but because of where CDS trade, this would be pretty onerous protection. Still, it is difficult to imagine a situation in which Italy and Spain would default within a year. These countries are not even under bailout regimes and, surely, more forces would be thrown into the battle, for instance the ECB, because if Spain and Italy defaulted it would probably mean the end of the euro area (so the incentives are aligned here). We acknowledge that the likelihood of BTP and Spanish bonds outperforming going into the one-year refinancing operation relies on the hypothesis that there is a sufficient number of investors confident that these countries will not default within a year.
But the difficult market conditions are supportive to the ECB carry trade. Basically, one would find it very difficult today to repo for one year Italian or Spanish government bonds. Liquidity has dried up significantly, especially for BTPei. In such a context where price guidance would be little better than a guesstimate, we think one could easily see these bonds repoing at Eonia +80bp today which would effectively bring the financing rate pretty close to that which will be offered by the ECB (1.5%). The distressed levels at which these markets trade make the ECB carry opportunity more attractive, in our view…
Indeed the late-2011 LTROs arrive at an apposite time for Italian debt.
The point is, it really is increasingly difficult for banks to park their Italian debt as collateral in private markets. Bloomberg reports only today that ATP, Denmark’s biggest pension fund, has ruled out accepting Italian or even French bonds as collateral. It’s a striking move, given how liquid these bonds are, or in Italy’s case, were.
It’s one reason we suspect why Italian banks, which warehouse much Italian government debt, have already been tapping the ECB in ever greater amounts. The total increased beyond €100bn in September, from €85bn in August and €41bn in July, according to the Bank of Italy’s balance sheet update released on Friday:
There is one other factor to consider that might complicate the carry trade this time, we’d argue, and that’s the ECB applying haircuts to sovereign bond collateral. Although how far they might vary the haircut by counterparty is anyone’s guess.
But clearly, carry-ing on in Italy = something to look out for.