Bad Collateral in Europe

Zero Hedge has been warning of this also. Dow down 130.

The Nightmare After Christmas

By Detlev Schlichter of The Cobden Center

The pathetic state of the global financial system was again on display this week. Stocks around the world go up when a major central bank pumps money into the financial system. They go down when the flow of money slows and when the intoxicating influence of the latest money injection wears off. Can anybody really take this seriously?
On Tuesday, the prospect of another gigantic cash infusion from the ECB’s printing press into Europe’s banking sector, which is in large part terminally ill but institutionally protected from dying, was enough to trigger the established Pavlovian reflexes among portfolio managers and traders.
None of this has anything to do with capitalism properly understood. None of this has anything to do with efficient capital allocation, with channelling savings into productive capital, or with evaluating entrepreneurship and rewarding innovation. This is the make-believe, get-rich-quick (or, increasingly, pretend-you-are-still-rich) world of state-managed fiat-money-socialism. The free market is dead. We just pretend it is still alive.
There are, of course those who are still under the illusion that this can go on forever. Or even that what we need is some shock-and-awe Über-money injection that will finally put an end to all that unhelpful worrying about excessive debt levels and overstretched balance sheets. Let’s print ourselves a merry little recovery.
How did Mr. Bernanke, the United States’ money-printer-in-chief put it in 2002? “Under a paper-money system, a determined government can always generate higher spending…” (Italics mine.)
Well, I think governments and central banks will get even more determined in 2012. And it is going to end in a proper disaster.
Lender of all resorts
Last week in one of their articles on the euro-mess, the Wall Street Journal Europe repeated a widely shared myth about the ECB: “With Germany’s backing, the ECB has so far refused to become a lender of last resort, …” This is, of course, nonsense. Even the laziest of 2011 year-end reviews will show that the ECB is precisely that: A committed funder of states and banks. Like all other central banks, the ECB has one overriding objective: to create a constant flow of new fiat money and thus cheap credit to an overstretched banking sector and an out-of-control welfare state that can no longer be funded by the private sector. That is what the ECB’s role is. The ECB is lender of last resort, first resort, and soon every resort.
Let’s look at the facts. The ECB started 2011 with record low policy rates. In the spring it thought it appropriate to consider an exit strategy. The ECB conducted a number of moderate rate hikes that have by now all been reversed. By the beginning of 2012 the ECB’s policy rates are again where they were at the beginning of 2011, at record low levels.
So why was the springtime attempt at “rate normalization” aborted? Because of deflationary risks? Hardly. Inflation is at 3 percent and thus not only higher than at the start of the year but also above the ECB’s official target.
The reason was simply this: states and banks needed a lender of last resort. The private market had lost confidence in the ability (willingness?) of certain euro-zone governments to ever repay their massive and constantly growing debt load. Certain states were thus cut off from cheap funding. The resulting re-pricing of sovereign bonds hit the banks and made it more challenging for them to finance their excessive balance sheets with money from their usual sources, not least U.S. money market funds.
So, in true lender-of-last resort fashion, the ECB had to conduct a U-turn and put those printing presses into high gear to fund states and banks at more convenient rates. While in a free market, lending rates are the result of the bargaining between lenders and borrowers, in the state-managed fiat money system, politicians and bureaucrats define what constitutes “sustainable” and “appropriate” interest rates for states and banks. The central bank has to deliver.
The ECB has not only helped with lower rates. Its balance sheet has expanded over the year by at least €490 billion, and is thus 24% larger than at the start of the year. This does not even include this week’s cash binge. The ECB is funding ever more European banks and is accepting weaker collateral against its loans. Many of these banks would be bust by now were it not for the constant subsidy of cheap and unlimited ECB credit. If that does not define a lender of last resort, what does?
And as I pointed out recently, the ECB’s self-imposed limit of €20 billion in weekly government bond purchases (an exercise in market manipulation and subsidization of spendthrift governments but shamelessly masked as an operation to allow for smooth transmission of monetary policy) is hardly a severe restriction. It would allow the ECB to expand its balance sheet by another €1 trillion a year. (The ECB is presently keeping its bond purchases well below €20 billion per week.)
Deflation? What deflation?
It is noteworthy that there still seems to be a widespread belief that all this money-printing will not lead to higher inflation because of the offsetting deflationary forces emanating from private bank deleveraging and fiscal austerity.
This is an argument I came across a lot when I had the chance in recent weeks to present the ideas behind my book to investors and hedge fund managers in London, Edinburgh and Milan. Indeed, even some of the people who share my outlook about the endgame of the fiat money system do believe that we could go through a period of falling prices first, at least for certain financial assets and real estate, before central bankers open the flood-gates completely and implement the type of no holds barred policy I mentioned above. Then, and only then will we see a dramatic rise in inflation expectations, a rise in money velocity and a sharp rise in official inflation readings.
Maybe. But I don’t think so. I consider it more likely that we go straight to higher inflation.
The deleveraging in the banking sector is the equivalent of austerity in the public sector: it is an idea. A promise. The reflationary policy of the central bank is a fact. And that policy actively works against private bank deleveraging and public sector debt reduction.
Consider this: The present credit crisis started in 2007. Yet, none of the major economies registered deflation. All are experiencing inflation, often above target levels and often rising. In the euro-area, over the past twelve months, the official inflation rate increased from 2 percent to 3 percent.
From the start of 2011 to the beginning of this month, the U.S. Federal Reserve boosted the monetary base by USD 560 billion, or 27 percent. So far this year, M1 increased by 17.5 percent and M2 by 9.5 percent.
Below is the so-called “true money supply” for the U.S. calculated by the Mises Institute.

As the Mises-Institute’s Doug French pointed out, total assets held by the six biggest banks in the U.S. increased by 39% over the past 5 years. Maybe this is not surprising given that in our brave new world of limitless fiat money, credit contraction is strictly verboten.
In the UK the official inflation reading is at around 5 percent, but nevertheless in October the Bank of England embarked on another round of “quantitative easing”. It has so far expanded its balance sheet by another £50 billion in not even three months, which constitutes balance sheet growth of about 20 percent.
What we have experienced in the UK in 2011 provides a good forecast in my view for the entire Western world for 2012: rising unemployment, weak or no growth, failure of the government to rein in spending, growing public debt, further expansion of the central bank’s balance sheet, rising inflation.
Death of a safe haven
And what about Switzerland? Here the central bank expanded its balance sheet by 40 percent over just the first three quarters of the year, and almost tripled the monetary base over the same period of time. Most of this even occurred before the 6^th of September, the day on which Mr. Hildebrand, the President of the Swiss National Bank, told the world and his fellow Swiss countrymen and women that the whole safe-haven idea was rubbish and that Switzerland was now joining the global fiat money race to the bottom.
Deflation has become the bogeyman of the policy establishment. It must be avoided at all cost! Of course for most of us regular folks deflation would simply mean a tendency toward lower prices. It would mean that the capacity of the capitalist economy to increase the productivity of labour through the accumulation of capital and to thus make things more affordable over time (a true measure of rising general wealth) would accurately be reflected in falling nominal prices. The purchasing power of money would increase over time. This, however, would require a form of hard and apolitical money. Instead we are constantly told that our economy needs never-ending monetary debasement in order to function properly. We are constantly told to fear nothing more than deflation, which can only be averted by a determined government and a determined central bank. And the never-ending supply of new fiat money.
Appropriately, there is no talk of exit strategies any longer.
Given the size of the already accumulated imbalances I think a stop to this madness of fiat money creation would be painful at first but hugely beneficial in the long run. I am the last to say that no risk of a very painful deflationary correction exists. But a correction is now unavoidable in any case, and every other policy option will make the endgame only worse. Even if I am wrong on the near-term outlook on inflation and even if all this money-printing does not lead to higher inflation readings imminently, it will still be a hugely disruptive policy. Money injections obstruct the dissolution of imbalances and invariably add new imbalances to the economy, including new debt and capital misallocations, that will make even more aggressive money printing necessary in the future.
The nationalization of money and credit
Herein lies a fundamental contradiction in our present system: The desire for constant inflation and constant credit expansion requires that the banks be shielded from the effects of their own business errors. Allowing capitalism’s most efficient regulators, profit and loss, to do the regulating, would mean that banks could face the risk of bankruptcy – this is, of course, the ultimate disciplinary force in capitalism. This could then lead to balance sheet correction and thus periods of deflation. Ergo, banks cannot be capitalist enterprises at full risk of bankruptcy as long as constant credit growth and inflation are the overriding policy goals. The constant growth of the banking sector must be guaranteed by the state through the unlimited provision of bank reserves from a lender-of-last resort central bank.
That banks get ever bigger, that they routinely hand out multi-million dollar bonuses, and that they frequently get bailed out, is not a result of the greed of the bankers – a stupid explanation anyway, only satisfactory to the intellectually challenged and perennially envious – but is integral to the fiat money system.
Banking under state protection ultimately means banking under state control. In the end it means state banking. And this is where we are going.
Last week the Federal Reserve and the Bank of England announced plans to tighten the control over the balance sheet management and the risk-taking of private banks. This is just the beginning, believe me. The nationalization of money and credit will intensify in 2012 and beyond. More regulation, more restriction, more control. Not only in defence of the bankrupt banks but also the bankrupt state. We will see curbs on trading, short-selling restrictions and various forms of capital controls.
A system of state fiat money is incompatible with capitalism. As the end of the present fiat money system is fast approaching the political class and the policy bureaucracy will try and defend it with everything at their disposal. For the foreseeable future, capitalism will, sadly, be the loser.
The conclusion from everything we have seen in 2011 is unquestionably that the global monetary system is on thin ice. Whether the house of cards will come tumbling down in 2012 nobody can say. When concerns about the fundability of the state and the soundness of fiat money, fully justified albeit still strangely subdued, finally lead to demands for higher risk premiums, upward pressure on interest rates will build. This will threaten the overextended credit edifice and will probably be countered with more aggressive central bank intervention. That is when it will get really interesting.
We live in dangerous times. Stay safe and enjoy the holidays.
In the meantime, the debasement of paper money continues.

Stocks Crash 160 Points From Their Zenith On More Eurozone Worries

from WSJ:
LONDON—European stock markets fell from session highs to trade only slightly in the black /now in the red/ Wednesday, as the outcome of the European Central Bank's longer-term refinancing operation scheme prompted concerns that the amount funding provided for banks may still not be enough...
The ECB beat market expectations by saying it allotted €489.19 billion ($639.96 billion) in the first of two keenly awaited three-year refinancing operations Wednesday. The central bank said it allotted the three-year loans—the longest maturity the ECB has ever offered—to 523 banks.
Although said to be positive for the banking industry, some warned that it may not be the answer to push banks to lend in order to prop up euro-zone sovereign bond markets.
"As the dust settles, the ambiguous nature of these data is perhaps coming in to focus—does this record LTRO take up imply carry trade support for the 'periphery' or more reflect banks' acute financing difficulties?" said Rabobank.

 I was amazed by this because I was trading live at 3:20 am when the news from the ECB broke and was initially positive and the market rocketed to its zenith. The S&P was up 10 points in just a couple of minutes. Then, reality apparently sunk in and both stocks and the Euro tanked. The Euro tanked first, crashing almost immediately. Needless to say, I am surprised to awaken this morning and see stocks in the red. Europe once again is the central focus of central bank shenanigans!

The Challenges for LTRO to Be Effective

From Peter Tchir of TF Market Advisors
Carry, LTRO, Data, and VIX
Once again we seem to have a discrepancy between what “credit” people think and what “equity” and “FX” people think.  The broad market rallied strongly today, at least in part because of the LTRO.
On one thing, everyone agrees, the take up rate will be high.  There will be strong demand for the LTRO.  What differs is the impact that will have on the market.
At one end is a belief that banks will be borrowing this money so they can purchase new assets.  The allure of carry will be too much to pass up, and with government encouragement, they will rush to purchase new sovereign debt and maybe even lend more.  That will turn the tide in the European debt crisis since there will be buyers for every new issue, and the market can move on to “strong” economic data in the US.
The other end of the spectrum is that the banks will use this facility to plug up existing holes in their borrowing.  They won’t have to rely on the wholesale market or repo market as much as they can tap this facility.  It will take some pressure off of the “money market” as banks won’t be scrambling for as much money every day, or over year end, but it won’t lead to new asset purchases by the banks.  Banks need to deleverage and that hasn’t changed.  The bonds can have a 0% risk weighting, but that doesn’t mean anyone, including the banks, believe it.  The road to hell is paved with carry.  That is an old adage and likely applies here. 
High Yield did well today (with HY17 outperforming HYG and JNK).  Investment Grade did okay as well (LQD tightened on a spread basis, though it shows up as a loss for most retail investors).  IG17 also was tighter as no one wanted to be hedged.  Away from that, more exotic trades, like curve trades didn’t show a similar strength.  These are the sorts of trades that would do well if everyone was looking for carry and thought the problems were solved.  Little things like that further underscore how likely it is that banks will participate.
Most banks are overexposed to these risks in the minds of investors anyways.  Will buying more of something that is risky really help?  Will loading up on a single position to the point that it can wipe you out be deemed as prudent?  I think banks that have managed themselves well to this point will be very reluctant to add significantly to their exposure.  You may get some token purchases so they can tell their regulators that they are playing nice, but beyond that, they will wait and see if the situation is really fixed.
The reason banks are not buying more of these bonds has little to do with funding costs being too high.  Risk and leverage are too high.  That hasn’t changed here, and most credit people believe that this new funding will encourage new asset purchases.  Without that, it helps the banks by reducing some uncertainty on their existing debt rollover needs (let’s not forget the hundreds of billions of bank issued debt that needs to be rolled this year), but doesn’t encourage asset purchases or balance sheet expansion.
Earlier today I had a bullish tone and did see 1300 and 1100 as being equally possible.  With a 40 point move from overnight lows it seems like a lot, especially since to the extent I was right, it was for all the wrong reasons.  I continue to believe that there may be an agenda behind the truth that is emanating out of Europe recently, but this LTRO plan doesn’t do it for me.  With our models showing seasonality being strongest from close of business tomorrow until the 27th, it is hard to be short, but without real news, we will be fading this.
On the data front, I am a bit confused why housing starts going up is a good thing.  The only industry that may be worse at predicting future demand than the airline industry, is the homebuilder industry.  They build homes, it’s what they do.  Carefully managing inventory to demand is not their strong suit.  A story about great demand and shortages of homes for sale would be much bigger news and may warrant a rally, I put this in a neutral category, at best.
On the earnings front, it seems like as many companies are missing as beating.  Oracle missed after the bell and is being punished.  It is far from clear to me that the earnings story is that compelling, and the strength in the dollar is the last thing the nascent surge in manufacturing needs.
We have a political system that couldn’t agree that the sun comes up in the morning without holding special sessions.  Their ability to provide any help to the economy is zilch and no matter how many times people say it, there is no strong evidence that “gridlock” and “a government that does nothing” is actually a good thing for stocks over the short term (even though it may be by far the best thing for the economy in the long run).
VIX is back to levels last seen in August.  The fact that those levels preceded a sell-off is largely being ignored on a day the DOW moved up 337 points, but as far as I can tell, VIX is as much a “risk on” / “risk off” asset as anything else and has limited predictive value (as in none).  Somewhere out there, the quants are analyzing the skew of longer dated options as a better tool that may retain predictive value, but that is complex, and requires effort, but is probably the work that is required to make some sense of what the “vol” market is telling us.  It is definitely the sort of work that serious tail risk hedge funds and quant funds are looking at and analyzing. 
Here is the “vol skew” graph function on the SPX on Bloomberg.  As far as I can tell you would need to be either a rocket scientist or a Deadhead to understand it.  I am neither, but am convinced that to the extent the vol market contains useful information, it is far more complex to figure out, than pulling up a VIX closing level. 

Europe's Sovereign Debt Crisis "Is Here to Stay"

by Felix Salmon at Reuters:

“By this time next week,” says Simone Foxman, “the euro crisis could be over”; she obviously doesn’t think much of Fitch’s analysis, which concludes that “a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach”.
I’m with Fitch on this one. But it’s worth looking at the bull case for the eurozone, as spelled out by the likes of Foxman and Tyler Cowen. At heart, it’s pretty simple:

1. The way to solve the euro crisis, at least for the next couple of years, is for the ECB to act as a lender of last resort.
2. The ECB is, quietly, doing just that — specifically by lending money for as long as three years against a much wider range of collateral than it accepted in the past.
3. Even though that money is going to banks rather than sovereigns, the banks will borrow as much as they can, at interest rates of about 1%, and invest the proceeds in Spanish and Italian debt yielding more like 6%, in a massive carry trade.
4. Which means that the ECB is, effectively, printing hundreds of billions of euros and lending it to distressed European sovereigns after all.

This, at least, is how Nicolas Sarkozy has been spinning things:

“Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”

But look at the headline of the article that quote appears in: “EU banks slash sovereign holdings”. Here’s a taster:

Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling €65bn of it in just nine months…
BNP Paribas cut its holdings by the most, shedding nearly €7bn of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with €28.7bn as at end-September. Deutsche Bank’s €6bn reduction was by far the biggest in percentage terms (66 per cent) and left the bank with just €3.2bn of GIIPS exposure.

My feeling is that, at the margin, banks are going to continue to reduce their holdings of PIIGS debt, rather than decide to follow in the footsteps of MF Global. But don’t take my word for it:

Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.
“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”
That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen says that “public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not” — and normally I’d be inclined to agree with him. Sovereign borrowing always crowds out other forms of bank lending, when a national government decides it really needs the money.
But in this case, it’s not going to happen. Why? For one thing, the main tool that governments can use has already been deployed: if banks load up on sovereign debt, it carries a lower risk weighting under Basel rules and therefore makes their risk-adjusted capital ratios look more attractive. But that’s been the case for decades now, and it can’t be beefed up at all. Meanwhile, bank regulators and investors are looking at a lot of other ratios too, like total leverage. And as we saw with MF Global, they’re hyper-aware of European sovereign exposures these days. Any bank wanting to be considered healthy will stay well away from Spanish and Italian debt.
On top of that, the financing needs of Spain and Italy are much bigger than their respective national banks can fill — especially in the context of those banks trying to deleverage, and seeing their deposit bases move steadily to safer European countries. While national governments are reasonably good at twisting the arms of their own domestic banks and forcing those banks to lend to their sovereigns, they’re much less good at twisting the arms of foreign banks and getting them to do the same thing. Is there any way at all for the Italian government to persuade French banks to lend to it? No.
And more generally, the national debt of big European sovereigns like Italy and Spain is so enormous that it has to be held broadly, in bonded form, by individuals and institutions. Banks alone won’t suffice. Greece is small enough that most of its debt can be held by banks. Italy, not so much.
There’s an argument that it doesn’t really matter whether the banks buy Italian and Spanish debt or not: the main thing that matters is that the ECB is printing money, which is entering the system via the banking system, and which will ultimately find its way into sovereign coffers one way or another, especially since there’s precious little demand for commercial bank loans these days. But I don’t buy it: there’s a virtually infinite number of potential investment opportunities around the world, and there’s no good reason to believe that the ECB’s cash is going to wind up funding Italy’s deficit rather than, say, getting invested in Facebook stock.
If Europe’s banks use ECB cash to deleverage and buy back their own high-yielding debt securities, the investors getting that money are not going to automatically buy sovereign bonds with the proceeds. Especially since those investors don’t care at all about Basel risk weightings.
So much as I’d love Sarko’s dream to come true, I don’t think it’s going to happen. The eurozone’s sovereign crisis is here to stay.

A Risk Assessment on ECB's LTRO

Posted by Lisa Pollack on Dec 19 17:10.
The FT has already reported on how hesitant banks are about buying ever more sovereign debt. In fact they outright dumped  €65bn of bonds in just nine months. Hopes that banks would hold the hand of the sovereigns that back them continue to dim, as the Sarko carry-trade looks increasingly less likely in advance of this Wednesday’s offer of cheap 3-year ECB financing.
The presumption that banks are going to use the 3-year Long Term Refinancing Operation (LTRO) to buy sovereign bonds comes not just from the dreams of certain politicians, but also from the observation that yields at the short end of peripheral curves have come in dramatically.
Spanish bonds provide an example (chart courtesy of SocGen):

From the above, European financials have deteriorated over the last week while the yields on Spain’s government bonds have been coming in. Is this the result of banks buying up the high yielding bonds that they will soon be able to fund exceptionally cheaply?
Not so much, say the analysts at SocGen in their Rates Strategy daily this Monday. There are many factors at play, and true, one of them may be the anticipation of banks putting on carry trades, but the expectations may not transform into reality.
For one thing, banks are going to have to find a way to fund their existing asset holdings — to the extent that they don’t deleverage themselves into nothingness, that is — and a good portion of the current funding for them will roll off in 2012. SocGen points out that for eurozone banks in 2012, €250bn of senior unsecured bank bonds will mature, along with €83bn of government guaranteed debt, plus €19bn of subordinated debt.
Seeing as the unsecured market is somewhere between frozen and inaccessibly expensive, the most relevant candidate for the replacement of that debt is reckoned to be around €185bn of covered bond issuance, a figure which the analysts acknowledge may well be a bit on the high side (though at least it will be supported by another ECB programme to specifically prop up that market).
The rest of the funding needs to come from somewhere. And, well, the ECB is offering…
True, the ECB ties up collateral as equally as covered bonds do, but there is an extra attraction to the LTRO: the banks that take the 3-year funding will in fact have the option to repay any part of it after just a year, hence freeing up the collateral held against the borrowing at the ECB. Nice option… that isn’t too consistent with the whole “carry trade” concept where the maturity of the asset is matched to the term of the funding for it, the rates team at SocGen points out.
Oh, and the collateral posted to the ECB can be relatively low quality. Not like the stuff required for private markets, or for covered bond pools.
One thing that actually joins the LTRO on the supply-side for liquidity, according to SocGen, is the lower reserve requirements that will kick in for the maintenance period starting on January 18th. Falling from two per cent to one per cent will free up some €100bn that was on deposit with the ECB — something that will happen in advance of the second 3-year LTRO at the end of February. However, the SocGen analysts expect that this move will more likely lead to a decrease in weekly main-refinancing operations (MROs), than a decrease in LTRO demand. One to be aware of, anyhow.
But back to how unlikely carry trades are:

There are several obstacles to carry operations, namely the stricter capital requirements, the pressure on banks to deleverage; and the stigma attached to such trades if ever revealed.

Put even more simply, do you think a bank that shows an increase in sovereign bond holdings in their quarterly reports will find it easier or harder to fund itself in private markets?
And what if there is yet another EBA stress test that whacks sovereign holdings and then demands additional capital for potential losses? How clever will a sovereign carry-trading bank look then?
In addition to that, if the bonds were to reverse course and start tanking again, the banks would have to post additional margin on them.
All of that said, could the banks make a dent if they wanted to? Out of some sense of patriotism perhaps? Emphasis ours:

Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).

That’s a “no” with words. Here’s the same with a graph, courtesy of Deutsche Bank with a couple of FT Alphaville modifications:

In the end, SocGen predicts a demand for €200bn on Wednesday.
RBC is in a similar ballpark, but warns that there’s a risk that the uptake could be lower than expected. There are currently already €350bn in excess reserves parked at the ECB which is much higher than they were prior to previous LTROs:

Furthermore, banks can fund the €432bn of tenders that mature this week with the weekly MRO and 3-month LTRO, so they don’t necessarily need to go to the 3-year tender just to keep things constant.
In addition to this, the RBC team notes that the exact details on the expanded range of eligible collateral hasn’t actually been decided yet, so it may not be clear to banks whether they have newly-eligible assets lying around that they may otherwise be willing to post.
In conclusion (emphasis ours):

A not too small outcome should suggest that banks use the new facility and get longer dated funding on board. This should sooth some anxiety about their funding risks going into 2012. A not too large outcome should also suggest that no unreasonable risks have been taken.

It’s the goldilocks of refinancing operations.

Market Expect's ECB to be Back-Door QE3, May Disappoint Market

from WSJ:
One of the things driving the market higher today is the idea that tomorrow’s Long Term Refinancing Operation by the ECB will serve as a back-door QE, bailing out the sovereigns and helping banks earn some easy cash with a carry trade.
The idea is fairly simple at first blush: European banks buy high-yielding sovereign debt, which they can pledge as collateral in the LTRO (of which there will be others in the future). The LTRO gives them cheap cash they can use to buy still more high-yielding sovereign debt, pocketing the yawning difference in borrowing costs.
This might help explain why recent auctions of peripheral European sovereign debt have been so well-received — banks were planning to turn right around and offer them to the ECB as collateral in exchange for a cheap loan.
Sounds good so far, but there are complications. Investors, already jittery about European banks, might balk if those banks take their cash and buy too much risky sovereign debt — against which they will also have to hold capital.
Peter Tchir of TF Market Advisors figures this will really end up solving a funding problem for the banks — as advertised, in fact — rather than waving a magic wand to resolve solvency problems of both sovereigns and banks:

Banks are struggling to borrow money right now to finance their existing positions.  How much of LTRO will be used to finance new bond purchases, rather than to replace existing forms of funding?  Any bank that is already running a big sovereign debt position will look to LTRO to replace existing forms of financing.  They can eliminate the repo roll risk on bonds they are financing in the repo market, or they could stop attempting to borrow in the interbank market.  Those are positives for the banks as they can earn more carry (cheaper financing) and reduce roll risk (3 year term).  But that doesn’t create new demand for bonds.
So the LTRO can help the banks with their existing funding problems without a doubt, but it is unclear that encourages new bond purchases.

Banks will have no real reason to buy up more sovereign debt, he suggests — particularly since they already own a lot:

To buy now, you need to believe that the default risk is gone.  Since NOTHING about this program addresses solvency, you cannot change your default assumptions.  You would be betting that the problem is really liquidity driven and that this program can solve that.  But how can you know that?  You need to assume every other bank will add significantly to their exposure.  No one bank can grow their exposure too large, without losing all access to the public debt markets and seeing their share price drop.  So each bank can only add incrementally.  Since the solvency problem hasn’t been addressed, you are buying in the hopes that some other bank buys too.  If everyone buys and takes on even greater exposure to these weak countries, then the liquidity and debt issuance risk can be addressed.  But what if strong banks don’t think it is smart to take on more risk.

Thus he thinks tomorrow’s LTRO will mainly be used for current financing needs, rather than taking big risky bets:

There will be significant interest in tapping the LTRO for existing positions.  Some small amount of incremental purchases may occur at the time, but the banks will use this to finance existing positions.  This should help bank credit spreads.  It should also show up in measurements like OIS as it would reduce pressure in the interbank funding market.  This is positive, but a relatively minor positive, and seems more than priced in.

Lisa Pollack at FT Alphaville had a very good post yesterday putting into perspective just how large the current funding needs of the banks already are — a hole that the LTRO will help plug, but not much more — certainly not embarking on a risky carry trade.
Marc Chandler agrees that this is no Trojan horse bearing QE:

Following the 1-year repo in June 09, there had been market talk of the money going into the short-term Italian and Spanish bonds.  Yet we don’t expect as much of new carry trades some officials might wish.  The lion’s share of the funds LTRO taken we suspect will go to 1) replace current ECB funding, 2) build greater cash buffer and 3) reduce some liabilities.  To the extent banks buy sovereign bonds, we think they are more likely to buy domestic bonds than foreign bonds.   The slope of curves may be an important consideration in whether banks take some duration risk.

But Chandler also thinks huge bank participation — something on the order of 250 billion to 500 billion euros — in tomorrow’s LTRO will be taken as a risk-on sign by the markets anyway.
Nomura currency maven Jens Nordvig, who recently closed his short-euro position when it dipped below $1.30, thinks it best for euro bears to step aside until the LTRO dust settles:

We have squared up our short EURUSD exposure at 1.30 last week, and we are in no major hurry to get back in. In the first instance, we will re-assess after the LTRO results are out tomorrow, but it may be better to wait patiently for fresh opportunities in January.

ECB's "Shell Game"

from Zero Hedge:
It is one thing for irreverent blogs to call a spade a spade an accuse the ECB of engaging in ponzi operations, such as Wednesday's LTRO where the European central bank will give local banks money and hope and pray the use of proceeds is to purchase sovereign debt (something we said previously is very unlikely to happen). It is something totally different when the world's biggest bond fund manager makes the same tacit accusation by saying that all the ECB does is take from one hand and give to the other - a very efficient shell game. Such as what Bill Gross has just done in a tweet from mintues ago. So how are investors, we wonder, supposed to have any faith in bonds (forget equities - they have long given up on those), when even the members of the status quo systematically undermine confidence in the global pyramid scheme (not that we are complaining).

ECB Pours Cold Water on Stocks

Unprecedented Coordinated Central Bank Interventions Stoke Stock Rally

Whisper rumors in the financial markets suggest that a major European bank was on the verge of collapse while we in the US were asleep last night. This was a massive coordinated intervention today by the central banks of China, Japan, Europe, Switzerland, and the United States. 37 major global banks' debt was downgraded yesterday by S&P shortly after the market closed.

Congressman Ron Paul released this statement this morning. I think he is absolutely correct in this. I couldn't have said it better if I was divinely inspired:


"Rather than calming markets, these arrangements should indicate just how frightened governments around the world are about the European financial crisis. Central banks are grasping at straws, hoping that flooding the world with money created out of thin air will somehow resolve a crisis caused by uncontrolled government spending and irresponsible debt issuance. Congress should not permit this type of open-ended commitment on the part of the Fed, a commitment which could easily run into the trillions of dollars. These dollar swaps are purely inflationary and will harm American consumers as much as any form of quantitative easing." -- Congressman Ron Paul
The Dow is up 400 points at this moment. Folks, do NOT misunderstand. This huge stock market rally today is a bet on INFLATION, not prosperity! This is an unprecedented intervention in the global financial markets by the central criminals -- also known as bankers -- as a panic move to stop what could be an imminent global banking meltdown.

This stock market rally is not due to expectations of renewed recovery. It is an oversized bet on massive inflation that will be the natural consequence of the excessive money creation and debt monetization that is being created.

Central banking and other monetary policy authorities are desperately trying to prevent what they see as certain calamity without such broad, coordinated, and extreme measures. What they fail to see in this short-sighted strategy is that with each succeeding threat of catastrophe, the magnitude and impact of it increases. They are just kicking the can down the road, with a bigger and more leaden can reappearing each time they do it. Don't be surprised if we see runs on banks before this crisis is resolved. They are already seeing bank runs (I've seen the photos) in parts of Europe right now just like the ones in the classic Jimmy Stewart movie, It's a Wonderful Life!

But Wait a MInute

Market Reacts Positively to ECB Announcement of Quantitative Easing

Markets Rocked, Terrible Turmoil

Jobless claims rose for one of the largest disappointments to consensus in memory. Stocks taking a hit, despite that Goldman is trying to makes excuses and brush this miss aside. If it is all due to "seasonal adjustments", then why didn't the consensus take that into account also? And ECB President Trichet is sounding dovish, sending the Dollar higher and Euro plunging. Meanwhile, the True Finns party, who just took power, is saying that Greece must default and is refusing any more bailout to the EU.

Results:

Dollar -- much higher
Euro -- much lower
Stocks -- moderately lower

Crude oil -- significantly lower
Commodity -- significantly lower
Gold and silver -- significantly lower

Also: commodity margins have been raised by exchanges over and over again over the past few weeks and months. Silver has been raised four times in less than two weeks. One silver contract on May 9th will require a margin of about $38,000 -- for ONE contract!

Eurodollar Futures Rocket Higher on ECB Rate Hike Likelihood

HONG KONG, April 4 (Reuters) - Eurodollar futures contracts expiring in March 2012 are forecasting a half point increase in U.S. interest rates, helped by increasing evidence that the economy is gaining momentum.
A widely expected rate increase by the European Central Bank on Thursday could also add pressure on the Federal Reserve to begin reversing its super-loose monetary policy.
Such an increase would be the ECB's first rate hike since October 2008 and widen interest rate differentials further between the U.S and Europe.
A surge in eurodollar futures in early March fuelled by expectations that the earthquake in Japan would stay the Fed's hand in tightening policy has taken a sharp U-turn in the past two weeks due to hawkish comments from some Fed officials.
While the disaster could push the Japanese economy back into recession for a few quarters, analysts now do not expect it to have a major impact on global economic growth.
Barclays strategists said the March employment report, which showed the U.S. jobless rate slipping to 8.8 percent, signaled a continuation of the trend towards solid business expansion, notwithstanding risks such as the Middle East unrest and rising commodity prices.
Even though the shift in rate expectations has led to some heavy profit-taking in the eurodollar and fed fund futures markets, a majority of analysts in a Reuters poll do not expect a rate hike in 2011. 
"The message here is that we do not believe the softness in the first quarter data should be interpreted as the start of a significant slowdown," they said.
Underlining that optimistic view, hawkish comments from some Fed officials hurt the market last week with two-year Treasuries , seen as among the most vulnerable to interest rate risk, underperforming longer-dated debt including 10-year notes.
Two-year notes briefly tested support at yields of around 0.89 percent on Friday, their highest levels since last May before subsiding to around 0.80 percent on Monday.
The gap between two-year and 10-year note yields has narrrowed to around 266 basis points from 283 bps on March 8.
Players in the fed fund futures markets are expecting about 40 bps of increase in U.S rates by March 2012.
Rate markets are also eyeing a speech by Fed chief Ben Bernanke later in the day where he might temper some of the recent hawkish comments by other Fed officials. (Editing by Kim Coghill)

ECB Acknowledges Inflation, Euro Surges, Dollar Plunges

Dollar

Euro

ECB Initiates New Program of Quantitative Easing (Monetization of Eurozone Debt)

If the Eurozone Central Bank is so "confident" of growth as they say, then why would this be necessary at all? These are not the actions of confidence, but of desperation!

from EuroIntelligence.com:

So much for phasing out the bond purchasing programme. The latest weekly ECB data suggest that the ECB bought €237m worth sovereign bonds last week, the highest since the middle of August, according to the FT. Still small in absolute size, the paper notes, it is a sign of continuing problems in eurozone bond markets. Irish traders last week reported that the ECB had been in the market to support Irish bonds, whose yield spread to German bunds rose to new record levels. The article suggested that the ECB was also buying Greek and Portuguese bonds.

About that ECB’s exit strategy

Ralph Atkins and David Oakley have an excellent analysis in the FT about the change in the ECB’s exit strategy. While a year ago it was the conventional wisdom inside the ECB that the banking support policy would have to be phased out, and only then could interest rates rise. That is no longer so. As banks have become dependent on generous ECB liquidity support, it is possible that the monetary tightening occurs while the liquidity policies are still in place.

European Commission optimistic about eurozone

The European Commission published its autumn forecast and, as ever, the news coverage is taking a national angle on this. El Pais is worrying about increasing growth divergences in the eurozone, with Spain falling far behind Germany with its 3.4% growth rate. The Portuguese newspaper Negocios didn’t even bother to report about any other country but Portugal, reporting that the European Commission said that Portugal has “an opportunity to recover” but that it must “intensify consolidation”.    For the eurozone as a whole GDP is forecasted to rise 1.7% this year (rather than  a previously projected 0.9%). La Repubblica picks on the Commission’s warning that labour market dynamics are still fragile.

ECB Intervening in Forex Markets

This appears to be the fourth intervention at 1.2150 since May 19th. These interventions cost the citizens of these countries staggering amounts of money, but ultimately achieve very little.

from Zero Hedge blog:


With all the grace of a drunk Keynesian at an Austrian economists meeting, the Central Banks once again kill the EUR shorts and intervene to prop it up, for a ridiculous 250 pips intraday move. And thanks to Germany's Economics Minister Rainer Bruderle, we now know that the Fed is actively manipulating the FX pairs. Thank you Ben Bernanke for making sure that Atari has some confidence left in the manipulated market, as no humans are left any more.

ECB Warns of 2nd Wave of Loan Losses, Financial Crisis

FRANKFURT/MADRID (Reuters) - The European Central Bank warned on Monday that euro zone banks face up to 195 billion euros in a "second wave" of potential loan losses over the next 18 months due to the financial crisis, and disclosed it had increased purchases of euro zone government bonds.
As the euro recouped losses but remained on the back foot after a cut in Spain's credit rating and China warned that the global economy remained vulnerable to sovereign debt risks, Spain assured investors it would reform its rigid labor market even if employers and trade unions cannot agree.
The ECB said euro zone banks would need to make provisions for further losses this year of 90 billion euros, and 105 billion in 2011, on top of some 238 billion euros in bad debts written off by the end of 2009. That was the first time it has given an estimate for next year.
Although total write-downs from bad loans and securities between 2007 and the end of 2010 were likely to be lower than previously expected, the ECB said in its latest Financial Stability Report, write-downs this year and next year would be still larger if heightened sovereign debt risk and the impact of government belt-tightening dragged down economic growth.
The ECB began buying up mostly Greek, Portuguese and Spanish bonds on May 3 in a contentious move to calm debt markets and support an $1 trillion stabilization package for the euro agreed by the European Union and the International Monetary Fund.
The central bank said in a statement it had settled 35 billion euros in bond purchases by May 28, up from 26.5 billion a week earlier. It did not detail the nationality of the debt but ECB officials have said it is mostly from south European countries hardest hit by financial market turmoil.
The ECB acknowledged in its report that euro zone debt tensions may force it to delay a phasing-out of cheap lending operations designed to help banks through the financial crisis.
After Lehman Brothers collapsed in September 2008, the ECB began offering euro zone banks unlimited, flat-rate loans in a bid to revive inter-bank lending and keep credit flowing to the real economy.
ECB governing council member Axel Weber, president of Germany's powerful Bundesbank, urged a tight cap on the bond buying program and said the extraordinary steps taken to ease the euro zone debt crisis posed a risk to price stability.
"The purchases of government bonds in the secondary market should not overshoot a tightly-capped limit," Weber said in a speech prepared for delivery in Mainz, Germany. He did not suggest a figure.
Spain, the fourth-largest euro zone economy, saw its credit rating downgraded a notch by Fitch Ratings agency from the maximum AAA to AA+ late on Friday after a 15 billion euro austerity program squeaked through parliament by a single vote.
Market reaction to the downgrade was limited, partly because U.S. and British markets were closed for holidays on Monday.
The euro recouped losses incurred after the Spanish debt downgrade to trade at around $1.23 but remained on the back foot as the downgrade highlighted ongoing structural weaknesses in the euro zone. The 10-year Spanish-German bond spread widened only slightly but Spanish stocks fell 0.7 percent while the index of leading European shares gained 0.4 percent.
Labor Reform
Spanish Economy Minister Elena Salgado told a conference in Madrid that the government aimed to pass a much anticipated labor market reform by the end of June with or without consensus with the unions and business representatives.
The minority Socialist administration extended the deadline for an agreement by one week from Monday but officials have said the social partners are still far apart.
The left-leaning daily El Pais said the government planned to allow companies to make greater use of cheap work contracts for a broader range of employees, reducing redundancy payments and making it easier to fire workers.
Trade unions have threatened to strike if the government imposes the reform by royal decree, a move that would set the ruling Socialists on a collision course with their traditional allies in organized labor.
In a sign of continued international concern about the impact of Europe's problems, China warned that Europe's struggle to contain ballooning debt posed a risk to global economic growth, raising the specter of a double-dip recession.
Premier Wen Jiabao, addressing business leaders during an official visit to Japan, issued his warnings a day after France admitted it would struggle to keep its top credit rating.
"Some countries have experienced sovereign debt crises, for example Greece. Is this kind of phenomenon over? Now it seems that it's not so simple," Wen said. "The sovereign debt crisis in some European countries may drag down Europe's economic recovery.
He added it was too early to wind down stimulus deployed during the 2007-2009 financial crisis.
Governments around the world ran up record debts during the $5 trillion effort to pull the economy out of its deepest slump since the Great Depression and now face a tough balancing act: how to reduce debt without choking off growth.
ECB Governing Council Member Mario Draghi warned that austerity programs by European governments could snuff out a fragile recovery unless they were coordinated internationally.
Economic sentiment in the euro zone fell in May, defying analysts expectations of a slight improvement, in part due to the wave of austerity announcements.
However, ECB President Jean-Claude Trichet said the economy may expand more than expected in the second quarter.
The fact that not just fiscally weak southern European countries, but also nations such as France and Germany at the euro zone's core are under pressure to cut debt and deficits amassed during the financial crisis, is adding to concerns.

Euro Continues to Build Solid Foundation

Just as occurred during the first half of 2008, the ECB has signalled an end to its interest rate easing cycle, and the Fed has signalled even easier money to come. Thus, the Euro is rising once again, and the Dollar is crumbling under the weight of fiscal and monetary ease. The Euro is now in a new bull cycle, and today's trading is symbolic of that longer term trend. This chart shows the new trend on the daily chart.

Trichet: Easing Cycle Ending

Jean-Claude Trichet seems to have signalled an end to the rate easing cycle of the European Central Bank, causing the Euro currency to strengthen over the past week or two.

Meanwhile, traders of Fed Fund futures are suggesting the possibility that the Fed may slash interest rates this week from the current 1% to just .25%. This would peg the interest rate for the Dollar at the lowest among the G-10, setting up a potential for a Dollar carry trade. This can only hurt the Dollar and stoke fears of renewed inflation.