Tick tock, tick tock: July 1 is fast approaching and with it comes a surge in analyst notes mulling the possible consequences of the expiry of the ECB’s 12-month long-term refinancing operation at the start of the month.
One of the latest is from Unicredit’s Luca Cazzulani, who puts the various different scenarios into context in terms of what they might mean for the market.
While Cazzulani admits it is difficult to ascertain the exact amount that is likely to be rolled over — i.e. carried over into the Bank’s medium-term operations — he suggests up to €50-70bn of speculatively tapped liquidity will be expired completely.
And that’s because current market conditions simply don’t cater to speculative demand the same way they did last year. As he explains:
There are several reasons why speculative demand should be very subdued this time. First, market conditions have changed dramatically. Last year, the repo market was not functioning properly and this made it attractive to use ECB funding for carry trades. Now it is cheaper to do it in the market.
Second, the bonds that were most appealing one year ago to set up carry-trades(those issued by peripheral countries) are those currently seen as more risky.
Third, the time horizon this time will be less attractive: only three months.
Which means those institutions which captured liquidity speculatively using peripheral bonds will be less inclined to commit themselves to the carry trade this time round.
As far as the expiry’s market impact goes, this will be determined by the level of demand for the ECB’s alternative liquidity facilities. As Cazzulani notes, these include:
There will be two options for investors wishing to roll over liquidity: on Wednesday, there will be the 3M LTRO, with settlement matched with the expiry of the 12M LTRO. On Thursday, there will be a 6D MRO (with announcement, allotment and settlement all on the same day.
The settlement will be matched with the expiry of the 12M LTRO). We expect most of the banks (and especially those in need of liquidity) to use the 3M LTRO. Participation at the 6D should be very marginal.
But the use of these facilities can’t be analysed without consideration of current excess liquidity, which has recently zoomed to €300bn from €160bn in response to the sovereign crisis.
Accordingly, the level of rollover required to keep the excess liquidity non-negative is €140bn. As Cazzulani explains:
If the amount of liquidity rolled over is only 140/150bn, the Eurosystem would revert to“neutral liquidity stance”. This would have a dramatic impact on MM rates, which would most likely jump back towards the refi rate. Bund yields would also suffer, as investors would price out the recent safe-haven rally. We think this is a low probability outcome: recent weeks have shown that the need for liquidity is actually quite strong.
That sort of take-up would suggest low liquidity needs in the system — something which should have the effect of normalising money market rates, pushing them back towards the refi rate. (Cazullani says this would be an unlikely scenario given current market stresses.)
Now, if €240/250bn was to be rolled over, this would imply things are much better than expected. In that scenario excess liquidity falls from €300bn to €100bn — limited liquidity needs — but enough liquidity remains to keep the system reassured. The result would probably dampen money market rates.
If €340/350bn is rolled over that too would assure abundant excess liquidity of about €200bn, and also no greater stress level than was seen back in the first months of 2010. Not a bad result, either.
However, if €400bn were to be rolled over…
…the excess liquidity would remain at current levels. This would be a very worrying signal, especially because, as we have pointed out,only banks with real liquidity needs are likely to participate in the auction. MM rates would remain at current levels, but Bund yields (and Treasuries to some extent) would likely rally. We think also this scenario is a low probability one.
In other words, this would be the worst-case scenario.
It’s worth pointing out the auction is also likely to reveal some important information regarding the makeup of the ECB’s reserves, according to Cazullani.
Given funding at the Bank is now 75 bps more expensive than the market on a one-week basis, and 50-55bps more expensive on a three-month basis:
This means that banks participating in the auction will reveal themselves as players with very difficult market access.
Related links:
July 1 could be the day liquidity dies - FT Alphaville
A short history of European liquidity – FT Alphaville
Onwards, upwards, forever, European liquidity – FT Alphaville
LTROpprobrium - FT Alphaville