What To Expect With The Ending Of LTRO 2

Includes: DIA, EWG, EWQ, IWM, SPY
by: Paulo Santos

Come February 28, the ECB will accept all (qualified) comers to a new iteration of the 3-year LTRO, here named LTRO 2. In this operation, the ECB will lend at a 3 year maturity, accepting a wide selection of assets as collateral.

As in the LTRO 1, which took place on December 21st 2011, the impact on the yields of assets acceptable as collateral has been immense. Below, we can clearly see the impact on Spanish 2 year government debt (source: Bloomberg):

click to enlarge

Right now the expectations for the amount of financing in the LTRO 2 range from 400 billion to as much as 1 trillion euros. After the announcement is made, this can have an unpredictable short term impact on the market.

However, there's something else that should be predictable about the LTRO 2, namely what will happen after February 28. Some might think that this operation will create amazing gobs of liquidity that will splash across markets. This, though, ignores something important: the impact of the LTRO, as seen in the chart above, happens before the date the financing is awarded, not after it because the assets to be delivered as collateral to the ECB are bought before the LTRO date, not after it.

So what is so predictable about what happens afterwards? What we can predict is that the same yields that benefited greatly from the operation will once again start a slow, steady, upward trend, with this movement starting within days of the operation. Why? It's rather simple; on one hand many of the institutions that constitute the demand side for these assets will have been sated well beyond the allocation limit they would usually take, so demand from these sources will tend towards zero.

On the other, the supply of these assets, namely, the supply of new government debt from several countries (Portugal, Italy, Spain, etc) will continue growing since they're all still running budget deficits. So we will have a sudden drop in demand meeting continuing supply. The resulting higher yields are thus predictable.

Also, the end of the LTRO 2 might well mean a stock market reaction similar to what happened after the end of QE1 and QE2 in the U.S. What happened then? Both times the major indexes took a nasty fall not long after those programs ended, as we can see for the S&P500 in the chart below.


Given the dynamics of the LTRO, where most asset purchases happen before the date these have to be delivered as collateral to the ECB, it is to be expected that as soon as LTRO 2 takes place, on February 28, the assets that benefited the most will start seeing increased yields. These increased yields might be seen as the resumption of the sovereign credit crisis.

Also, it can happen (but is less certain) that, much like after the end of QE1 and QE2, the stock market will eventually react negatively to the now-absent support from ongoing monetary dilution. This would be a potential negative for the main stock indexes - such as S&P500 (NYSEARCA:SPY), Nasdaq (NDX), Dow Jones (NYSEARCA:DIA) and Russell 2000 (NYSEARCA:IWM) as well as the European indexes such as those tracked by the iShares MSCI Germany Index Fund (NYSEARCA:EWG) or iShares MSCI France Index Fund (NYSEARCA:EWQ).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.