DKK Forwards - Implications Of The Euro Liquidity Drain‏

From 30 January banks have been allowed to repay the ECB the EUR489bn borrowed in the 3Y LTRO of December 2011 and from 27 February they will be able to repay the EUR521bn borrowed in the second 3Y LTRO. Hence, excess liquidity in the euro zone is declining.

The result has been higher European money market rates, upward pressure on EUR/DKK and the first Danish independent rate hike.

A full normalisation of the European market should imply the return of a positive Danish rate spread (i.e. further Danish hikes) and a neutral EUR/DKK forward curve.

The market is currently pricing another 30-40bp of hikes in Denmark by year-end, which might prove too aggressive. The 2010 euro liquidity drain shows that EUR/DKK forwards can widen again if Denmark does not hike fast enough relative to the rise in euro money market rates.

We recommend using the recent market normalisation in EUR/DKK forwards to hedge EUR assets/income at longer tenors.

Banks are starting to repay the 3Y LTRO money
The first opportunity to repay the 3Y LTRO from December 2011 saw banks give back EUR137bn of the EUR489bn borrowed. This was higher than expected by the market and might indicate that our forecast of EUR200bn to be repaid over the first months is too low (see EUR Strategy: Aggressive pricing of impact from LTRO repayment, 22 January).

However, as history suggests that a liquidity drain has almost no impact on the money market when excess liquidity is above EUR300bn, our rate strategy team concludes that money market rates are unlikely to move much higher over the coming months. The modest EUR3.5bn LTRO repayment seen this week supports this view.

Implications for Denmark – defining a ‘normal’ market
That European banks are beginning to repay the LTRO money is a sign of markets normalising: the strong banks can once again get unsecured funding in the market at low rates, eurozone break-up concerns have eased and, in general, the demand for precautionary liquidity buffers has eased and risk sentiment has improved. The 24 January independent Danish rate hike of 10bp is part of this normalisation.

Before looking at the detailed implications for the Danish market, it is thus worth asking the question: what would a full normalisation imply for Denmark?

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