Last Thoughts on LTRO

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At this late date there still seems to be a great deal of misunderstanding and uncertainty surrounding Wed's 3-year LTRO by the ECB.

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Ironically even the size of the first LTRO is unclear. Many observers and the media continue to cite the take down as 523 bln euros. That is true, but is misconstrued. The bulk of that amount reflected the rolling over of other borrowings. The net injection was about 191 bln euros.

The second LTRO will similarly be inflated. There are approximately 150 bln euros in ECB lending maturing in the next couple of months that will likely be rolled into the 3-year facility. In addition, Tuesday's 1-day fine tuning tender for 134 bln euros, while the 7-day tender drew slight interest (29.5 bln euros) would seem to point to a roll-over component of LTRO II to be on par with LTRO I, perhaps a little less (332 bln euros rolled into LTRO I).

A key question is how much do the European banks need. At the end of last year the ECB estimated that European banks around 550 bln euros for 2012. From this some observers subtract the net injection of LTRO I. This gives financing needs of about 360 bln euros.

On one hand this may exaggerate the real financing needs as banks, especially Spanish and Italian banks, which are expected to be significant participants in LTRO II, have been able to raise funds in the market. That is one of the results of LTRO I.

On the other hand, banks do not seem to be borrowing only to cover this year's funding needs. It is three year money after all, though there is the option to return the money after one year. They have access to 1% funds and banks (e.g Spanish and Italian banks) appear to have increased the percentage of assets invested in their own sovereign bonds. This is a type of low risk carry trade, which is not always picking up pennies in front of the steam roller as it is often depicted.

The size of the participation may be an important factor in assessing the market's response. The general (unscientifically determined) view seems that the larger than participation, the better for what are regarded as risk assets (equities, emerging market, peripheral bond markets, commodities), including the euro. The consensus appear to be around 500 bln euros.

Even if this assessment is true, there is another consideration that few have given much thought to; namely that we should expect the markets to respond differently to what very well may be the last LTRO than the first. Buy the rumor, sell the fact may not quite capture this point, though that remains a risk as well. When a central bank begins an easing cycle, the market's response is typically different than when market believes it is the last move.

There does not seem yet to be much fallout from the ECB's decision grant all official creditors senior status over all private sector creditors. Just today, the European Investment Bank claimed it too will not be subject to the PSI. This has some implication not just for the bonds that the official sector holds, but also for the collateral. The ECB has the first claim if one of the institutions it lent to fails.

This suggests that a new stigma may have arisen by the ECB's decision that did not exist in LTRO I. Admittedly this is conjecture, but there has been a change in ranking of creditors and this is something to which investors are sensitive.

Fundamentals aside, the euro's technical position is constructive. It has spent Monday and Tuesday consolidating the gains from the second half of last week. The chart formation on the daily bar charts warns of the likelihood of another leg up. We have been warning that a move above $1.3200-50 would target $1.34-$1.36. A break of the steep uptrend line, which now roughly corresponds to the 5-day moving average (~$1.3385) would call into question the constructive technical picture.