ECB Rumors and the Euro

Rumors circulated the markets today that as early as this weekend the ECB will announced a 600 bln euro 1-year loan facility. Just yesterday the ECB had a chance to do this, but as we know declined to do anything. Perhaps, the ECB was protesting the political pressure brought to bear on it recently and consequently sat on its hands. However, if the ECB does announce a facility over the weekend, outside its regular meetings, it would also appear to be back tracking. The price will be more erosion of its credibility.

The funding pressures are acute. That is probably what the banks told the ECB in their meeting today. Moreover, recall that last year the ECB provided unlimited 12-month funding at 1%. That operation needs to be unwound in several weeks and there was a need in any event, leaving Greece aside, to manage this process. Some term refinancing facility is desired and needed. It is not immediately clear why the ECB did not move in this direction yesterday.

The euro has found some support from these rumors. Judging from the one-day operation the BOJ felt compelled to do, the pressures on TIBOR, EURIBOR and LIBOR and on the index-swaps, the funding pressure requires a policy response. If it does not materialize over the weekend, the euro may be sold. Next week's refi operation will take on greater significance. Demand is likely to be very strong. Re-activating swap lines with the Federal Reserve also remains a distinct possibility.

The issue is not just about sovereign debt issues any more. It is threatening the stability of the banking system. And it is beyond this too. For example, yesterday, reports indicate, that two German real estate funds moved to stop redemptions after a exodus was triggered by the German government bill that sought to shrink the assets of the industry by 10%. Of course, as we noted earlier, the German election this weekend in the most populated state could see the governing coalition to lose its majority in the upper chamber of the German parliament, which would call the CDU's agenda into question.

Lastly, despite the gains the euro is registering today, partly encouraged by these rumors, we note that the risk-reversal--which measures the relative price of puts and calls equi-distant from the money--shows that participants are paying the biggest premium for euro puts than they did even as the euro was collapsing in Q4 08. This warns of the fragility of today's upticks in the euro.

A new term facility from the ECB is arguably necessary. But even if it materializes over the weekend and helps ease the funding issues,it may not be sufficient to offer lasting support for the euro.