TLTRO impact questioned as the carry trade provides easy money

The Eurozone banks' longer-term borrowings from the central banking system continue to decline, a trend that many economists view as a form of  "passive" tightening in the area's monetary conditions.

LTRO balance outstanding (source: ECB)

As discussed earlier (see post), the ECB will attempt to replace some €400bn of the lost balances with a new program dubbed TLTRO ("targeted" LTRO). Here is the official description:

The ECB: - Counterparties will be entitled to an initial TLTRO borrowing allowance (initial allowance) equal to 7% of the total amount of their loans to the euro area non-financial private sector, excluding loans to households for house purchase, outstanding on 30 April 2014. In two successive TLTROs to be conducted in September and December 2014, counterparties will be able to borrow an amount that cumulatively does not exceed this initial allowance.

During the period from March 2015 to June 2016, all counterparties will be able to borrow additional amounts in a series of TLTROs conducted quarterly. These additional amounts can cumulatively reach up to three times each counterparty’s net lending to the euro area non-financial private sector, excluding loans to households for house purchase, provided between 30 April 2014 and the respective allotment reference date in excess of a specified benchmark. The benchmark will be determined by taking into account each counterparty’s net lending to the euro area non-financial private sector, excluding loans to households for house purchase, recorded in the 12-month period up to 30 April 2014. All TLTROs will mature in September 2018.

The interest rate on the TLTROs will be fixed over the life of each operation at the rate on the Eurosystem’s main refinancing operations (MROs) prevailing at the time of take-up, plus a fixed spread of 10 basis points. Interest will be paid in arrears when the borrowing is repaid.

Starting 24 months after each TLTRO, counterparties will have the option to repay any part of the amounts they were allotted in that TLTRO at a six-monthly frequency.

Counterparties that have borrowed under the TLTROs and whose net lending to the euro area non-financial private sector, excluding loans to households for house purchase, in the period from 1 May 2014 to 30 April 2016 is below the benchmark will be required to pay back borrowings in September 2016.

The goal here is not just to pump up the Eurosystem's balance sheet, but, more importantly, to stem the relentless declines in corporate and household credit growth. The rationale for excluding mortgages apparently stems from fears of igniting another property bubble.

The portion in blue is particularly important. The ECB is "waiving a carrot" in front of the banking system: "do more lending over the next year and we will reward you with cheap funding."

Some argue that the TLTRO offering is useless because there is no demand for credit in the euro area. That's simply not true. The private sector credit supply/demand imbalance has widened significantly over the past year. Given the tepid growth in the Eurozone, the availability of credit is vital to maintaining the recovery. The ECB has finally given up on the notion of "creditless expansion" (see post).

Source: Credit Suisse

The biggest hurtle for the TLTRO program is the banks' unwillingness to grow private credit. The area's banks' ability to borrow based on their "loans to the euro area non-financial private sector" does not mean that they plow the new funds into the private sector. In fact analysts expect banks to borrow at 0.25% fixed for 4 years from the central bank and use a good portion of the proceeds to buy government paper that yields significantly more. Even at 0.37%, Spanish 1-year notes would be profitable for banks as a "carry trade".

Spanish 1-y government bond yield (source: Investing.com)

Part of the reason for this concern is the constant pressure to deleverage and tougher capital requirements under the new Basel rules. Short-term sovereign paper meets both, the minimal additional capital requirements as well as the liquidity criteria that banks are looking for. Why bother with personnel-heavy loan underwriting, high capital charges and illiquidity when there is easy money to be made. Government paper is in effect crowding out private credit.

Reuters: - Many analysts believe that, while bonds yields have narrowed substantially since the last LTRO, there is still an appealing carry compared with the 0.25% the ECB is charging for the funds. Sovereign debt carry trades will be doubly appealing because banks do not have to hold additional capital against such positions - but do against corporate bonds, loans to businesses and other assets.

"Carry trade yields have come down, but there is still money to be made," said Jon Peace, a bank analyst at Nomura. "With the zero risk-weighting on sovereign bonds, the carry trade will continue to appeal."

The carry trade will make the banking system the largest beneficiary of this program - as was the case in the previous 3-year LTRO offering. European bank shares are up some 60% over the past couple of years. Yet over the same period, private sector loans outstanding have been steadily declining. Some point to this program as being another example of central banks helping bank shareholders and irresponsible governments without significant benefits to the overall economy.

The argument from the ECB would be that only banks with large loan portfolios will be "rewarded" with this cheap financing, providing some level of incentives (particularly compared to the previous LTRO program). Furthermore, the improved bank profitability resulting from TLTRO is expected to help with the deleveraging process, which should result in a stronger banking system.

However, with all the easy money to be made in government bonds, the impact of the program on private sector credit expansion remains unknown.
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SoberLook.com

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Eurozone investors jump on the carry trade

Another recent survey seems to indicate that the Eurozone institutional investors are taking on more periphery risk. With the ECB backstop in place (see discussion), investors in the area have shifted to being long periphery debt vs. the core. Given this increased appetite for risk, should the expected ECB aid to Spain fail to materialize (see discussion), the selloff could be quite violent.

JPMorgan: - Investors have shifted their peripheral positioning to long in recent weeks which could become a risk for intra-EMU spread tightener trades.

Source: JPMorgan

For now however the carry trade in the Eurozone is on.

SoberLook.com

I love the smell of volatility in the morning

The markets stopped caring about 09 volatility and had been focused on 2010. The thought was that 09 will leave with a whimper because of the (government stimulus driven) benign economic data and Fed's inaction. And that's what the shape of the VIX futures curve was implying as participants bid up longer dated options relative to short dated ones.





Next year is when all the action was supposed to take place. But the reversal of the Risk Trade brought the volatility back into 09. Many got caught short vega with near-term maturities (some were long 2010 vega and short 2009 vega). Forced covering flattened the VIX futures curve in a day. Maybe Q4 markets won't be as boring as some had expected.

SoberLook.com

Roubini blasts the risk trade

The emergence of the risk trade on a large scale, which we discussed earlier is starting to get some attention.

Bloomberg: Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” ... “Everybody’s playing the same game and this game is becoming dangerous.”

One disturbing component of this pattern is gold becoming part of the risk trade as well - it's now highly correlated with equities. This is in part due to pending commodity "anti-speculation" regulation, which doesn't apply to gold. That makes gold the ultimate proxy for the liquid commodity risk trade. But a high correlation between gold and equities is somewhat absurd, because generally what's good for gold is not that good for corporations. The only rational explanation is that the weak dollar benefits both.

The risk trade is now showing signs of fatigue. As the year draws to a close we may see more of the carry trade reversal - as traders convert risk back into dollars.



But the only thing that can truly slow down the risk trade momentum in the months to come will be a change in direction for the US monetary policy. And that looks unlikely for quite some time.

SoberLook.com

Liquid risk strategies are highly correlated

What does the Australian dollar (AUD) have to do with global equity markets? Fundamentally at first glance not that much. Australian equity market cap is a small fraction of the global markets. But the data shows something else. The chart below shows the regression plot between AUD and the MSCI World Index (global equity index) since Sep-08. The R^2 for the regression is 0.75, pointing to the fact that a large part of AUD/USD movements are explained by the global equity markets. One gets a similar result for the AUD/JPY cross.

AUD/USD vs. the MSCI World Index

source: Bloomberg


In contrast however, Dollar/Yen shows little relationship to the global equity markets (see chart below).

USD/JPY vs. the MSCI World Index

source: Bloomberg


What's going on here? What's so special about our friends down under? It turns out that it has less to do with Australia and more to do with correlated risk taking. We discussed this before in the context of the "carry trade".

Imagine the global markets as continuously jumping in and out of liquid risk trades. A risk trade is anything that produces positive returns when we have an "all is well for now" feel around the world. If no scary things happen a risk trade should do well, but as soon as something spooks the markets, the risk trade gets unwound. That's why it needs to be liquid.

The two most liquid risk trades are global equities and currency carry trades (long a currency with high interest rate and short a currency with low interest rate). We all know why equities represent a risky trade. The carry trade is also risky because it tends to be highly leveraged. Some may argue that commodities are in that camp as well, although liquidity there is not as high (relative to currencies and equities). That means that when traders put on risk, some go long equities, others put on the carry trade. When they jump out, the reverse happens. The key is that they do it simultaneously (usually it's different sets of people who trade these). That's why the correlation works for AUD/USD and AUD/JPY - both of these are a high rate currency against a low rate currency, i.e. carry trades. USD/JPY is not a carry trade, thus the correlation to equities is insignificant.

The lesson here is simple: if you have liquid risk strategies, expect them to be correlated, no matter what the asset class is. That is why those who think diversification will significantly cut their risk are surprised every time when seemingly unrelated markets/strategies become correlated.

The US dollar is now the currency of choice for the carry trade

With the collapse of US interest rates, the dollar is replacing the Yen as the "carry trade" base currency. It's an easy trade to put on, even for a retail investor. A dealer or a fund can simply sell dollars forward against another currency. This trade is equivalent to borrowing dollars, converting them to another currency and lending the currency for a period of time. The interest expense on the borrow is significantly lower than the income from the lending because of the interest rate differential between dollars and the other currency. For example, the three month Euro LIBOR is 0.72%, while the dollar rate for the same maturity is under 0.3%.

Putting this trade on with the Australian Dollar gives about a 3% annualized rate differential (the trade of course could be one week, 3 months, etc., depending on the optimal point on the curve and other considerations).



But what makes this trade interesting for many is the amount of leverage one can get, even as a retail investor. A currency futures contract (see attached futures specs) may require less than 2% initial margin (50:1), creating 150% annualized return assuming FX rates stay where they are. So not only is the investor betting against the dollar, but even if the exchange rate doesn't move from current spot levels, the trade has a nice return. Of course in reality one needs much more capital than the initial margin because the dollar could rally as it did today, forcing either a variation margin posting or an unwind.

For those brave souls who really like risk, a Brazilian Real trade may be just the thing. The rate differential is over 11% annualized.

Of course this trade is getting increasingly crowded. The dollar is now viewed as a safe-haven currency, and any sudden perceived increase in global economic or geopolitical risk could precipitate a sudden dollar rally, forcing a violent carry unwind.





Important: this is not any type of investment advice, just an observation.