AMSTERDAM—Economic data did not rock European financial markets last week as the focus was on the first round of 36-month European Central Bank (ECB) refinancing operations.
French GDP for the third quarter disappointed a bit, coming in at 0.3 percent quarterly growth versus the 0.4 percent expected. U.K. GDP on the other hand came in slightly higher than expectations, with 0.6 percent growth versus the 0.5 percent expected quarter on quarter.
The important Ifo business sentiment indicator out of Germany also surprised a bit to the upside, rising to 107.2 this month from 106.6 in November. The consensus forecast was for a drop to 106.
The Euro Stoxx 50 benchmark equity index closed at 2,290 points, gaining 3.98 percent last week in relatively volatile trading. The euro currency gained 0.34 percent to close at $1.3056, after trading as high as $1.3201 but then giving up most of those gains later in the week.
European Refinancing Takes Center Stage
The ECB has similar ways of managing its refinancing operations as the Federal Reserve. It normally manages short-term rates—the main refinancing rate, which is similar to the federal funds rate—through so-called main refinancing operations (MRO), which have a maturity of one week. Those tender offers can be rolled many times as long as the banks have the collateral eligible for the loan, but they do carry significant interest rate risk and therefore banks cannot invest these loans in longer term assets.
This is why in times of financing distress the ECB has the flexibility to introduce longer term refinancing operations (LTRO), which last longer than the MRO. Last week the ECB tendered an unlimited amount of liquidity at a maturity of 36 months for the first time ever.
The funds, lent at the main refinancing rate of 1 percent, now can be used by banks to invest in longer term assets, such as three-year government debt, with no interest rate risk.
Huge Take Up of LTRO Excites Markets
Societe Generale analyst Klaus Baader points out in a report, however, that the net amount was much smaller, as the LTROs replaced existing refinancing operations such as the MRO. According to his calculations, the net amount was 210 billion euros ($274 billion) but he pointed out that nonetheless the operation could have positive effects: “The maturity of those funds has lengthened drastically, which will give banks more planning certainty and will hopefully support lending to households and enterprises as well as creating additional demand for bonds issued by the hard-pressed southern European member states.”
Some Skepticism Remains
But as it is so often the case with European policy, hangover after the brief euphoria came quickly.
Instead of using the funds straight away to buy sovereign bonds or pay down existing expensive debt, the banks deposited a total of 82 billion euros ($107 billion) with the ECB at its deposit facility. While this operation can be reversed at any time, it does mean that the banks are now paying 1 percent to the ECB for the lending, while receiving 0.25 percent for the deposit facility.
But even if the banks were to invest the total net amount in the so called “carry trade,” UBS analyst Atsushi Ito says that profits will not be enough to offset capital shortfalls. In his report he outlines that banks are going to be required by the regulator to increase their capital by 114.7 billion euros ($149 billion) by the end of June 2012.
Using the example of buying three-year Spanish bonds, banks would make a profit of 2.7 billion euros ($3.52 billion) until the capital deadline and it would not be enough to offset the shortfall.
The Week Ahead
Bond auctions will include Italy auctioning 10-year bonds and a large amount of bills maturing in June 2012. It is unlikely that this will provide the potential to upset the markets, but as 2011 draws to an end, everything is possible in light volume trading.
No significant economic data or news about the different bailout mechanisms are expected. Thanks to the ECB and the Fed, the banks should have ample liquidity for the rest of this year, so this should be a rather uneventful week ahead.
