Banks Park LTRO Cash at ECB, Key Test as Italy to Sell 20B in Bonds This Week

LTRO Increases Credit to Banks by €210B

Last week we saw the ECB lending out to European banks and its largest refinancing operation in history. However if you look a little closer at the figures we see that it resulted in a net increase of around 200 tend to Europe

From ZeroHedge: "The first-ever 3-year liquidity operation by the ECB was an unqualified success. Banks bid for a greater-than-expected €489.2bn, making this the largest-ever single refinancing operation in the ECB's history.
However, this is not the net amount by which outstanding ECB open market operations have increased. Because banks reduced their use of the Main Refinancing Operation (MRO) by €123bn yesterday, and also the use of 3-month long-term refinancing operations (LTROs) by €111bn allotted today, the net increase is smaller.
Moreover, several banks made use of the possibility to swap out of the recent 12m LTRO that was allotted in October into the new 32-month facility (123 out of 181), to the tune of €46bn. So the net increase in outstanding open market operations is about €210b."

Banks can use this funds one of four ways:

1. Banks could shore up balance sheets as European banks need to raise around €115 billion in order to meet fresh capital requirements.
2. They could use this money to buy sovereign bonds, in effect conducting a carry trade by borrowing at 1% from the ECB and buying Italian or Spanish or other periphery debt that yields higher amounts and pocketing the difference. Having been burned by exposure to sovereign debt, the banks may be reluctant to follow this strategy.
3. They could use the money to lend to businesses and households - the key priority for the ECB which does not want to see austerity by governments coincide with a pullback in lending by banks which need to meet new capital requirements.
4. Banks could park the money back with the ECB at its deposit facility which pays 0.25% interest, which is actually a negative carry but it would mean banks have access to cash when needed - a piggy bank.

The action that banks take will have important impact on the health of the European banking sector as well as on the health of the economy. If they decide to lend money that could mitigate the impact on the European economy from the pullback in government spending. If they borrow the money and buy sovereign debt that can help keep yields in the periphery from rising to dangerous levels. However if they simply hoard the cash it may have a minimal impact, except it would help give banks more security in regards to their own funding needs.

Banks Park That Cash in ECB Deposit Facility

Coming out of the weekend it seems that banks have chosen to take the fourth option described above which is to park most of the funds with the ECB.

From Spiegel: "This week has seen the level of deposits at the ECB's overnight facility rise to close to €412 billion ($538.4 billion) — the greatest amount seen since the euro's introduction, and representing a single overnight increase on Monday of €65 billion.
Normally banks tend to lend any excess funds to each other. By doing so, they can make more money — especially given that interest rates at banks are currently twice as high as those offered by the ECB. But the interbank market has been disrupted for weeks now, prompting concerns that the credit crunch last seen after the collapse of Lehman Brothers has returned. European banks no longer trust each other because it is unclear to what extent individual banks are exposed to government bonds from countries hit by the debt crisis, and whether those institutions are in jeopardy. Instead, they are turning to the ECB as a safe haven for their money."

Here is a look at the ECB depost facility's usage via ZeroHedge:

Italy to Sell 20B This Week, Highlight in European Bond Markets

The key event this week therefore in European bond markets will be Italy attempting to sell about €20 billion of debt.

From Bloomberg: "German notes rose, pushing the rate on two-year notes to less than 0.2 percent for the first time, as investors sought the safest assets before Italy auctions as much as 20 billion euros ($26.2 billion) of debt.
Italy plans to sell 9 billion euros of 179-day bills and as much as 2.5 billion euros of zero-coupon notes due in 2013 tomorrow. It will offer bonds due between 2014 and 2022 on Dec. 29."

With thin liquidity we'll see what appetite there is for those bonds following the LTRO action by the ECB.

From CNBC: "The 10-year is the area where Italy has to rely more on foreign investors and it will be very tough to sell especially at this point in the year, so I expect further cheapening of the bond going into the auction," ING rate strategist Alessandro Giansanti said.
"The three-year would be easier to sell, there is some demand from the domestic investors. If they see really weak demand in the 10-year … they may sell more short-term (debt)."
"(The Italian auction) is the main event this week," one trader said. "There's almost no liquidity out there, (investors) are just getting their books ready for next year, it's going to be very thin all week.""

A drop in the yield that Italy has to pay would be a positive sign and we should be looking to see if we can get a better bid-to-cover ratio. However if we see higher yields and weaker demand that it shows that banks do not have any appetite for Italian bonds even after if it means positive carry trade as a result. Still, with liquidity thin we shouldn't give too much weight to the auction, though it may have an immediate impact on European markets and therefore the EUR/USD in this week's trading.