This week, Europe’s banks have their first window of opportunity to pony up the funds and repay cash borrowed under the European Central Bank’s (ECB) long-term refinancing operations (LTRO).
This has made money markets nervous. The primary measure of European interbank credit pricing, Eonia, recorded its largest one-day jump in more than a year on 17 January, with 12-month swaps pricing in an equivalent of €500 billion in liquidity draining from the market, or an entire 1% rate rise.
Continental banks have been reeling in euro-denominated funds at a rate of knots, with repatriation being one of the contributing factors in the rapid appreciation of the currency against the dollar from its lows last year.
Cover ratios and bidders at the ECB’s bond-purchase sterilisation auctions have steadily fallen over the past year as banks have become increasingly liquidity sensitive, and the last of 2012 undersubscribed.
Almost $1 trillion in funds borrowed under the LTRO remain deposited at the ECB. At the time of going to press, it was unclear how much would be returned, but most analysts reckoned $500 billion was over-egging concerns. And to some, therein lies the opportunity.
‘We estimate that 2013 repayments could be of around €100-€250 billion,’ said Bank of America Merrill Lynch rates strategist Sphia Salim.
‘We see two main reasons why banks may now pay back part of their three-year LTROs. Some (mainly in core countries) may have borrowed funds only to build buffers in case eurozone funding markets were to totally collapse. These funds, if deposited back at the ECB, would be earning a penalising negative 75 basis point carry.
‘Some (mainly in peripheral countries) may want to signal to the market that they are able to reduce their reliance on ECB funding.’
Salim believes that having bottomed in late 2012, rates will now become more volatile, but that ultimately rates will be forced back down by ECB strong-arming, or macro pressures. Backing a flattening of the Eonia yield curve over nine to 12 months is an obvious opportunity, he says.
Despite mixed messages from the central bank at the beginning of 2013, president Mario Draghi would be unlikely to accept a sustained increase in interbank financing costs.
If pressures did not subside, ‘it would be open to the ECB to react by cutting its official interest rates’, according to Monument Securities analyst Stephen Lewis.
‘There would then merely be a change in the spread between official and market rates, with market rates gravitating back to levels at which they stood prior to the LTRO repayment.
‘Since the ECB aims to maintain accommodative monetary conditions, it may well be expected to take such action on its own lending rates, if the need arises.’
More broadly, the emphasis on bank access to markets illustrates what some – in particular the ECB – are calling a bottoming in the credit cycle. While the transmission to the real economy remains tentative to non-existent, the onward chain is no longer being blocked by weak bank balance sheets.
RBS, for instance, reported at the end of the year that it had been able to reduce its ‘non-core’ book of potentially dubious credit assets from £258 billion in 2008 to £65 billion at the end of Q3 2012.
‘It has allowed them to recover on mark-to-market terms far better than they ever could have envisioned,’ said Barnes. ‘Banks have had so much opportunity to be made whole.’
He added that the recent falls in the most competitive consumer saving rates to fresh historic lows illustrate their increased flexibility in the cost of capital.
While not a screaming buy, subordinated lower-tier long-maturity financial debt remain at fair value, said Barnes, versus an otherwise overpriced market.