European Cheap Money Injection: What to Expect

The results of the European Central Bank’s second mass release of loans at very low interest rates into the European banking system are being closely watched by markets on Wednesday.

Euro bank notes in a briefcase
Photo: Medioimages | Photodisc | Getty Images
Euro bank notes in a briefcase

The central bank’s first three-year long-term refinancing operation in December was hailed as a success from almost all across the euro zone. Viewed as Europe’s answer to quantitative easing , the first round was credited with spurring this year’s stock market rally and cautious return to confidence.

The first time around, the market underestimated how popular the three-year long-term refinancing operation (LTRO) would be — and how positive its effects could be — until traders returned to their desks after the Christmas break.

With the second round, there are a number of key questions to ask before deciding how to play it.

How Big Will It Be?

Analysts’ estimates for the second round have gradually been reduced, with most now believing that it will be similar to the first operation of 489 billion euros ($654 billion).

If the sum taken out is below 400 billion euros, this may also be viewed as positive, according to Peter Schaffrik, head of European interest rate strategy at Royal Bank of Canada, as it could indicate that banks do not need the new source of funding.

How Much of the Total Sum Is Actual “New Money”?

In the first operation, banks also slashed their use of the existing Main Refinancing operation and of the shorter, three-month LTROs, in favor of the new facility, making the net increase in outstanding ECB open market operations only around 210 billion euros.

This time around, analysts are predicting up to 300 billion will be new liquidity, as many of the MROs have already been taken out of the system.

How Will It Affect Markets?

In the immediate aftermath of the LTRO, a large takeup by European banks should help boost the recent risk rally in stock markets — which could in the long term help bolster the recovery around the world.

The second round of LTRO will be “almost as important for the U.S.” as for Europe, according to analysts at Bank of America Merrill Lynch.

A lot will depend on how banks use their new source of financing. If they choose to lend it, or to buy sovereign bonds, they could help struggling euro zone economies. If it is used just to bolster their own balance sheets, critics fear it will merely postpone the euro zone’s troubles until later.

The euro should be boosted slightly against the dollar in the short term, unless take-up is much higher or lower than expected, according to Lauren Rosborough, senior currency strategist at Societe Generale.

While there was a boost to peripheral bond yields — which were at close to unsustainable levels for countries including Italy — following the first operation, analysts at Bank of America Merrill Lynch warned that yields look less attractive second time around. The amount banks charge each other for lending should continue to gradually decrease.

When Will It Start Helping the Real Economy?

This is possibly the most important question of all — and the area where the ECB’s action is most open to criticism.

So-called “broad money” and bank lending both rose in January after falling toward the end of 2011, according to ECB data, which analysts at Credit Suisse believe is an encouraging sign that the “disorderly deleveraging” of the European banking system has halted.

Banks also continued to buy debt in troubled peripheral countries such as Spain and Italy, driving down their bond yields. And the deposit outflow in peripheral economies (apart from Greece) also halted following the operation, indicating that some consumer confidence is returning.

Yet the growth in demand for mortgages and other consumer-focused lending is still slowing, and the gloom across the euro zone has not lifted. Most economists still expect the region to fall into recession this quarter.

Ultimately, the most important effect which the LTRO has on the man in the street may be that its bolstering of the banking sector helps make a sustained recession less likely.