The much-awaited 12-month Long-Term Refinancing Operation (LTRO) held on September 29 resulted in a total allotment of EUR 75.2bn in favor of 589 banks. The outcome is at the low end of the forecasts spectrum (ranging from EUR 50bn to EUR 300bn) and below our bet of a result within the EUR 125-175bn interval. More important is the fact that both the amount allotted and the number of bidders were much lower than in June, when a total amount of EUR 442bn was injected in favor of 1125 banks.
A segmented banking market?
The combined reading of the LTRO outcome and of the latest Euro money market survey published by the ECB on September 24 allows an assessment of the ongoing situation in money markets, and of the effectiveness of ECB measures adopted so far (http://www.ecb.int/pub/pdf/other/euromoneymarketsurvey200909en.pdf).
The still-gloomy situation depicted by the Euro money market survey should be of no surprise given that it captures only very partially the effect of the June LTRO. In a nutshell, the main message is that, compared to the second quarter of 2008, the unsecured interbank market kept shrinking from 11% (overnight, lending side) up to 46% (longer term between 3- and 12-month). It’s hard to say given that we do not have the exact amounts, but our impression is that if we compare the decline (in absolute terms) experienced by interbank lending with the true collapse experienced by other forms of short-term funding, say the euro-denominated commercial paper, we come back to the conclusion that it is not the unsecured interbank market – already anemic at long maturities before the crisis erupted – that has disappeared, rather other key sources of liquidity (e.g., money market funds).
With no manoeuvre on rates in sight in the near term, the market focus remains centered on ECB unconventional measures aimed at sustaining the banking sector with the final objective of restoring a sound credit flow in favor of the real economy. As President Trichet has made very clear in his hearing before the Economic and Monetary Affairs Committee of the European Parliament on September 28, the time to exit has not yet come. Recent signals on the financial sector shape are undoubtedly positive but the crisis is not over yet and, as implied by Mr. Bini Smaghi recently, there might be the case that a non-negligible part of the banking sector remains addicted to ECB liquidity.
At a first sight, results of the September LTRO are encouraging, and my boss Marco Annunziata has already talked of “ongoing normalization”. However, as he has clearly stressed, it is too early to claim “mission accomplished”. A few weeks ago, in discussing the outcome of the June LTRO, we mentioned three reasons that in our view, more than others, helped to explain the huge size of the allotment. They were 1) true funding needs; 2) liquidity ratios; 3) favorable market conditions. All of them were less binding last week. Liquidity ratios are computed mostly on a 1- to 6-month basis, and they should have been already fulfilled by the previous tender. Market conditions remain favorable (very steep yield curve on the 2-10-year segment) but the financial year is closing, budget targets have been met and, as the pressure on the short end of the curve immediately after the announcement of the LTRO outcome shows, the bond market remains subject to several factors that may trigger an abrupt sell-off anytime. For those banks asking liquidity back in June mainly to ride the curve, there was no need to push further. Funding needs were less binding too: with the risk that the ECB would have applied a spread in September (remember that Trichet clarified the issue only at the September press conference), banks in true need of liquidity already had the chance to buy a good deal of relief in June.
A closer look at the result raises more than one question mark. True, the signal is reassuring if one looks at the overall systemic liquidity conditions. However, while the gross size has reduced by 83% (to EUR 75.2bn from the prior EUR 442.2bn), the number of bidders has declined by “only” 47% (from 1121 to 589). Moreover, the average amount allotted is very small (EUR 128mn). With all the caveats of a back-of-the-envelope reasoning like this, one is authorized to think that it was mainly small- and medium-sized banks to participate. It looks to us like an indirect confirmation that this bunch of players still experiences impaired access conditions to liquidity markets and remain largely dependent on ECB liquidity. Finally, if liquidity conditions are easing significantly as somebody argues, it remains to be explained why at the last weekly MRO, just to give you an example, an amount of almost EUR 67bn(!) has been allotted at the “expensive” 1% rate, with market rates for unsecured (1-week Euribor) and secured funding (1-week Eurepo), both at 0.35%. Our impression is that there is a non-negligible part of the banking system plainly cut-off from market funding.
The next LTRO is scheduled for mid-December and remains to be seen if the ECB will decide to apply a spread on the allotment rate (now at 1%) in order to signal to markets that at least a part of the unconventional support may be unwound. It is too early to say and in our view it will remain a close call until the ECB will signal its intentions, very likely at the December Council meeting. Clearly, if our assumption on the two-tier banking system is correct, it’s hard to imagine that the ECB will apply a spread because it’s unlikely that a dramatic improvement in systemic liquidity conditions may occur between now and the end of the year. The cautious reading of recent evidence by Trichet and other Council members is another indirect signal that the guard in Frankfurt remains very high. For the time being, the ECB keeps proving that its “credit easing” policy has been dramatically effective in preventing a credit crunch and in unclogging, to a certain extent, operations in money markets. The precipice is definitely behind us but the exit is not nigh.
ECB October meeting: wait and see!
A further confirmation that the central bank keeps treating the recovery with a good deal of caution will come at the October policy meeting scheduled for next Thursday. Recent data suggest a moderate growth pickup in the third quarter, set to find further ground before the end of the year. However, a strong recovery appears very unlikely, and the current massive slack, the worst legacy of the economic collapse of Q2 2008-Q2 2009, will take a long time to be worked off. We do not expect major changes in the rhetoric from last meeting when staff forecasts for 2010 GDP stroke a very pessimistic note. President Trichet will likely repeat that the bulk of ECB’s credit easing measures put banks in the condition to extend credit in favor of the real economy. However, if successful in avoiding a credit crunch, the ECB can do little to jumpstart a strong recovery in the lending market where supply to risky borrowers is rationed and demand from sound agents is very scarce. Inflation stays negative, and the tail of a deflation scenario is thinner than a few months ago but has not yet disappeared from the radar screen.
Trichet will repeat also that there is no pre-defined path to the exit, meaning that depending on how the macro and financial situations unfold, the ECB may decide either to lift the policy rate first (inflation risks on the rise) or to unwind unconventional measures (sounder banking system) before removing traditional accommodation. If we are right on the (tame) inflation outlook and a sluggish recovery, we remain convinced that a higher refi rate will be the last step. This holds particularly true in an economy like the euro area where a stronger banking sector is a very necessary condition for a sustainable recovery.
Dr. Aurelio Maccario
Chief Eurozone Economist