Were you puzzled by the immediate reaction of the euro following Wednesday’s LTRO?
Icap’s Don Smith, has a rather compelling interpretation.
And it’s all to do with currency basis swaps and the ECB’s dollar funding operation:
As Smith explains (emphasis ours):
It might appear odd to some, that in the wake of yesterday’s massive US $33bn allocation at the ECB’s extended 14-day US$ tender to cover the holiday period (against $5.1bn maturing from the previous week), eur/usd basis has moved lower, signalling at face value that this massive US$ tender has had little effect in satiating US$ demand from Eurozone banks, so what’s going on?
By way of background, the short-end eur/usd cross currency basis curve (3month maturity in particular) has become something of a barometer of demand for US$ and indirectly global risk aversion (which is associated with such demand). The more negative this basis the greater the relative demand for US$ versus € and it has moved to some extremely negative levels of late. Naturally the recent occasions when the US$ funds have been made more available to eurozone banks have caused the basis to move less negative as US$ demand has been partly satiated. The co-ordinated central bank announcement on 30th November which lowered the rate offered on US$ tenders from US$ OIS +1% to US$ OIS + 50bp, triggered a massive jump in 3-month eur/usd basis from -163bp to -130bp and news of the jump in US$ allocation at the ECB’s weekly 7-day US$ tender on Wed 15th Dec triggered a move from -152 up to -127bp. So why hasn’t yesterday’s much larger than expected US$ allocation moved the basis higher again?
The key reason relates to the relative nature of these basis markets. The eur/usd basis represents a barometer of demand for US$ relative to euros. And big as it was, yesterday’s US$ tender occurred at the same time as the ECB has completed flooded the Eurozone money market with euro cash through its 1-week, 3-month, but especially its 3-year euro tenders. We think that around €210bn of this was new funding, the remainder being sourced from the maturing 3-month LTRO (€111bn), the 7-day OMO (€123bn) and October’s 1-year LTRO (€46bn).
The effect of this deluge of euro cash has been to all-but obliterate strength on the bid-side of the eur/usd basis market (ie those willing to accept euro in exchange for US$). As a result, reduced demand to receive US$ through the basis (or forward FX markets) in the aftermath of yesterday’s US$ supply, which would typically drive the basis higher and offer a signal that US$ demand has been partly satiated has had little effect because on the other side of this trade, demand to receive euros (in exchange for US$) gas dropped even further due to the ECB’s euro liquidity splurge.
In short, so much euro liquidity hit the market that it didn’t matter that the ECB had just had a successful dollar funding operation. No one was willing to price currency basis swaps in any other way but one which reflected a dollar drought situation during a euro flood.
In such a situation, the euro has no choice but to fall.