ECB's Long-Term Repo Operation

The ECB will conduct its first 3-year repo operation tomorrow. Yet it is already having an influence on the capital markets. Some banks are thought to have been buying short-term Spanish and Italian bonds that will ostensibly be used for collateral, for example. In turn the generally good reception last week to the Spanish 5-year bond auction and the bill auctions this week have helped spur a bit of a short-covering bounce in the euro--with record net short speculative positions at the IMM.

With the gains scored in the North American session, the euro has retraced almost 38.2% of the decline since the Dec 8 high. That comes in near $1.3142, while today's high has been $1.3132. The euro's bounce helped drag up the other major and emerging market currencies. As we have noted the correlation between the euro and the US stock market is largely matched by many foreign currencies high correlation with the euro.

The long-term repo operation (LTRO) is the main event of the week. Today's ECB operation may contain useful information for tomorrow's event. The ECB offered one-day financing to bridge the maturing 7-day repo and tomorrow's operations. There is also funds that will freed up from the expiring 12-month and 3-month operations.

Tomorrow banks can chose between a 7-day facility, 3-month facility and the 3-year LTRO. When taking all this into account and incorporating the experience of the first LTRO--a 1 year operation in June 2009, when 442 bln euros were taken down, we suspect that the results will be at the upper end of market expectations. These appear to range from about 100 bln euros to 400 bln.

Banks appear to be under some pressure to participate in the long-term operation, and there are reasons why some need persuading. Excessive reserves are running higher and the cut in required reserves starting in the middle of next month will increase the excess reserves. Banks in general are engaged in de-leveraging. It is one thing to replace maturing funding, prevent a passive drain and secure funding in case the markets are not conducive next year, it is another thing to re-leverage.

Following the 1-year repo in June 09, there had been market talk of the money going into the short-term Italian and Spanish bonds. Yet we don't expect as much of new carry trades some officials might wish. The lion's share of the funds LTRO taken we suspect will go to 1) replace current ECB funding, 2) build greater cash buffer and 3) reduce some liabilities. To the extent banks buy sovereign bonds, we think they are more likely to buy domestic bonds than foreign bonds. The slope of curves may be an important consideration in whether banks take some duration risk.

The risk is that the thinner holiday markets will hamper/exaggerate the market's reaction. All else being equal we suspect that a take down 250 bln euro to 500 bln euros, depending on the use of the shorter term facilities, will be seen as a favorable development for risk-taking appetites.

Over the slightly longer term, we look for the ECB to cut rates in Q1 and expect the euro to decline further. In fact, our "muddling through" hypothesis is helped not hindered by a weaker euro.