Market Overview

Chances of LTRO3? Don't Count On It...

The European Central Bank (ECB) is set to hold a meeting on Thursday, July 5. Economists are predicting a 25 basis point cut in the bank's headline rate to 0.75 percent from 1.0 percent. As the European Debt Crisis continues, economists speculate that this rate cut is needed to help the ailing European economy.

In late 2011, ECB President Mario Draghi launched two rounds of cheap financing for financial institutions in Europe. These rounds are known as the Longer-Term Refinancing Operations (LTROs). The LTROs, three-year collateralized loans with low one percent interest rates, successfully un-froze European credit markets. Some may wonder if the ECB is set to launch another round of cheap lending, or LTRO3 for short.

On Tuesday, the ECB commented that countries should only be able to use government backed bank bonds as collateral in exceptional circumstances. This all but killed the hopes of LTRO3 because these bonds were the ones used, especially by Italian banks, as collateral in the previous LTROs.

The TED Spread, a measure of the difference between the short-term borrowing costs of the U.S. government and financial institutions, has stayed around 40 basis points since the LTRO's went into effect. Prior to these LTRO's, the Ted Spread had widened almost to 60 basis points. This widening showed that borrowing costs for financial institutions were rising and funding markets were contracting. As the TED Spread is currently less extreme than it was prior to the LTROs, the chances of LTRO3 may be low.

Further LTROs would likely improve sovereign bond markets, as the funds of the first two Operations were used largely to buy sovereign debt and thus drove down yields of peripheral nations. The same dynamic also sent German Bund yields to record lows. However, following recent announcements from the Eurogroup summit, sovereign spreads narrowed. The Spanish 2-year bond yield has fallen approximately 120 basis points since before the summit started. Thus, there may be no need for further stimulus at the moment.

LTRO3 would likely weaken the euro against the U.S. dollar, as this currency pair has tracked the balance sheet expansion of the respective central banks rather well. However, the EUR/USD might see a short-term jump on the news, as bullish sentiment weakens the dollar against a basket of currencies, including the euro.

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