Three reasons to fade the rally on higher LTRO2 uptake

Three reasons to fade the rally on higher LTRO2 uptake – February 28, 2012, 05:02 GMT

Disclaimer: This is in no way my professional recommendation and due discretion should be undertaken when making any trades

 

1. Sovereign bond carry trade is unlikely to continue

a. Yields are no longer attractive on a risk:reward basis

Peripheral bond yields have come sharply off their highs. 10 year BTPs now yield about 5.42% (as of this article) compared with close to 7% pre-LTRO1. This brings it roughly in line with “fair-value” pre-LTRO1 (~5.7%). This leaves almost zero room for further downside meaning banks would more likely invest the funds in other less risky assets (Australian/New Zealand bonds yield comparably lucrative yields at almost zero risk). Heck, the banks might even decide to hoard the cash considering 1% isn’t much to pay.

b. ECB’s foolish move

By swapping its Greek bond holdings to avoid the newly enacted CAC, future investors are likely to think twice about investing in risky debt since they are effectively placed in a subverted class. This is a far cry from the suggested handling of ECB holdings pre-LTRO1 whereby the ECB would swap its holdings into the EFSF and let the fund stomach the losses.

 

2. Structural issues still remain

a. Peripheral debt is still risky

The Italian technocratic government has yet to prove it is able to bring down its ballooning debt and with the risk of contagion still high, current bond yields are not reflecting the underlying risk holding such debt entails. Portugal, for that matter, still has bond yields hovering near 13% which will be unsustainable if no further bailout is provided.

b. EURUSD has recovered roughly 10% from its lows

The northern European countries, which are the primary creditors for whatever firewall Europe plan’s to put up, are predominantly export oriented. It is no coincidence that the drop in the EURUSD coincided with the pick-up in German business activity. With the rest of Europe in a recession, the EUR needs to stay low so that the countries can export their way out of it. Sadly, competitive devaluation seems to be the name of the game now and German business activity is likely to adjust downward sharply pretty soon. This means the Germans are unlikely to raise their commitments to the future enlarged firewall required.

 

3. Whatever resultant rally will be knee-jerk and unsustainable

a. No LTRO

Clearly this effect would be unlike persistently low interest rates where resultant economic activity can be sustained.

b. Not a form of easing

LTRO is only granted to banks. As explained above, and banks have no incentive to pass on this liquidity to the economy at large. Since the extra liquidity is unlikely to find its way to the economy, there is no reason that ANY supply side improvements will follow and hence no resultant improvement in competitiveness.

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