Signs That The Effects Of LTRO Are Over

by: Macro and Cheese

The ECB met yesterday to set monetary policy, and despite the simplicity of the agenda, the questions in the followup Q&A session with the press were typically hard-hitting. Early on, ECB President Draghi fielded a question from a reporter with a German newspaper. The reporter asked about the effects of LTRO given the poor Spanish bond auction that had taken place just prior to the ECB meeting:

Is it right to conclude from (the auction) that in a way the beneficial effects (of LTRO) are about to vanish as far as their market impact is concerned?

Draghi had an answer, but not for that particular question. "I would read the recent developments not so much as an example of market fragility, but simply as an example that markets are expecting reforms," he said. He explained that banks had a "window" that they could take advantage of to repair their balance sheets. He added, throwing water on the idea of another LTRO operation any time soon, that LTRO provided liquidity, not capital.

But we don't need Draghi to answer the question, the markets are giving us a clear indication on the matter. Below is a series of charts with very little commentary, apart from a few circles and arrows to highlight the relevant patterns. First, let's review the impact of LTRO on two key markets, notably US and German stocks. First the US (all charts courtesy Bloomberg):

LTRO SPXClick to enlarge

As highlighted in the oval, the first installment of LTRO occurred on December 21 of last year. Similar to the reaction to QEI and QEII, US equity markets have gotten a very positive boost from LTRO. Here is the German market over the same period:

LTRO DAXClick to enlarge

As we see, the German market has also reacted very positively to LTRO, but we can detect a hint of a change of course over the past few weeks, and a divergence from the S&P. This is even clearer if we look at the relative strength of the DAX to the S&P 500, simply by dividing the price of the DAX by the price of the S&P:

DAX-SPXClick to enlarge

Note that the DAX very clearly outperformed the S&P until mid-February, then moved sideways for a month, and since mid-March has underperformed, particularly yesterday, when DAX futures declined by 3% compared to a loss of just over 1% by the S&P. This is a clear indication that the benefits of what is a completely European initiative are starting to wane.

This phenomenon is visible, surprisingly, even in Japan:

LTRO NikkeiClick to enlarge

Here we can see that LTRO appears to have been a powerful catalyst to drive the Nikkei up to its post-earthquake high, but now the market has hit some turbulence. We can see a similar phenomenon, but in reverse, with the cost of insuring Italian government bonds, namely, the Italy CDS spread:

ITALY CDSClick to enlarge

Note that although the cost of insurance is still lower than it was on December 21, nearly half of the benefit has now been reversed, much of that reversal taking place over the past two weeks. We can see the same kind of deterioration with Spanish 5-year government bond yields:

Spain 5-yearClick to enlarge

Here, as of yesterday, Spain's borrowing cost is actually higher than it was on the day of the first LTRO operation 3 1/2 months ago. The benefits of LTRO for Spain seem to have run their course. We've observed the effects of LTRO on Italian and Spanish sovereigns, but what about European banks, the direct beneficiaries of LTRO? Here is a chart of the stock price of Credit Agricole, one of France's three largest banks, generally perceived to be the largest participants in LTRO borrowing:

Credit AgricoleClick to enlarge

As we see, any benefit to Credit Agricole has now disappeared. Not convinced? Banco Santander, Spain's largest bank, closed yesterday at EUR 5.41; on December 21 it closed at EUR 5.72. ING Bank, Holland's largest, is hanging on to a small increase in price since December 21 but as of yesterday had erased all but the initial two weeks of gains following the initial December 21 LTRO operation.

Even the Eurozone currency has had little overall net movement since LTRO's initiation, unlike the dollar, which weakened materially during the two Fed quantitative easing initiatives:

EUR chartClick to enlarge

Perhaps the biggest reason of all to suspect that the effects of LTRO will wane is that despite the very positive result of providing 800 EC banks with liquidity, the loan proceeds have yet to work their way out into the real world. Although the two LTRO operations amounted to over EUR 1 trillion, about half of that was in "new loans," the other half being simply existing loans rolled over. As we see in the following chart of overnight bank deposits at the ECB, virtually all of the new loan proceeds are still with the central bank:

ECB depositsClick to enlarge

The green circles represent the dates of the two LTRO operations. Immediately following each of them, overnight deposits rose by almost exactly the amount of the net new loans. Banks have borrowed the money for three years, and have yet to do anything with it. In other words, banks have been protecting themselves for a rainy day. There is nothing wrong with that, but since virtually no new funds have entered the economy, there is little reason to expect asset prices to rise beyond the impact of the improved liquidity position of the EC financial system. As far as markets are concerned, LTRO seems to have run its course.

Disclosure: I am short the S&P 500, the Nasdaq, and the DAX.