Gaming The TLTRO

Scotland's referendum seems to overshadow this week's key events. Yet, for the most part, it is a binary event. Either Scotland votes to be independent of the England and Wales or it doesn't. An independent Scotland would be a surprise even though the polls show a statistical dead heat. It would send sterling reeling. The betting (as opposed to speculating) clearly favors Scotland choosing to remain in the union. This will likely shoot sterling higher, and keep the expectation for a Q1 15 BOE rate hike intact.

The two-day FOMC meeting that begins today is only slightly more nuanced. The Federal Reserve will update its forecasts, and Yellen holds a press conference tomorrow. These pose some headline risks. However, the key really lies in the forward guidance. Does the FOMC continue to say that rates can remain low for "considerable time" after the end of QE or doesn't it? Does it still characterize the labor market is significantly under-utilized? Any change in the language will reinforce ideas that the Fed is moving toward its first rate hike. In her press conference, Yellen is likely to reinforce the message that the economic data will shape the timing, pace and magnitude of the normalization of monetary policy.

The ECB launch of its new facility (Targeted Long Term Repo Operation) is arguably more nuanced than the Scottish referendum or the FOMC meeting. The issue here is the extent of the participation. The strength of the participation is expected to have knock-on effects on European bonds directly, and indirectly through shaping expectations for the asset-backed bond/covered bond purchase scheme whose details will be provided next month.

There are two phases of the TLTRO. The first will be launched Thursday and will follow up in December. The amount that can be borrowed in this phase is a function of banks' current loan book. In the second phase, which starts in March 2015 and will run through the middle of 2016, borrowing will be more a function of the change in the banks' loan book.

Under the first phase, it has been estimated that about 400 bln euros can be borrowed from the ECB. However, a Bloomberg survey found that the consensus expects a draw down of only 310 bln euros. This sum is divided between 150 bln euros this week and 160 bln euros at the December 11 opportunity. The Bloomberg survey found that the total participation in the TLTRO is expected to be 575 bln euros, down from 620 bln initially expected.

Although the 10 bp rate cut the ECB announced last week has been routinely dismissed as symbolic, it boosts the likelihood of better participation at the TLTRO. The funds are available at a rate of 10 bp on top of the refi rate (now at 5 bp). Banks in the periphery and weaker banks in the core are the most likely candidates to use the TLTRO funding to replace the more expensive LTRO and other wholesale funding. These banks are thought to account for the lion's share of the approximately 350 bln euros LTRO funds that come due in January and February 2015.

Draghi has indicated he wants to boost the ECB's balance sheet back to the level that prevailed in early 2012. This will require a bit more than 1 trillion euros, given that the LTRO paydowns will weigh on the balance sheet. This gives the ECB's action a quantitative easing, although many pundits refer to it as QE-lite, in a derogatory way to distinguish it from the sovereign bond purchases of the Federal Reserve and Bank of England. In fairness, the BOJ also buys private assets, including commercial paper, ETFs and REITs. And a trillion euro boost in the ECB's balance sheet can hardly be fairly called "lite."

The difference between the take down of the TLTRO and the trillion plus expansion of the balance sheet Draghi has indicated will come from the other initiative announced last week: the asset-backed securities and covered bond purchases. The ECB will buy the senior tranches--the least risky--part of the ABS. It wants simple and transparent securities, though the precise definition of that criteria appears to vary country-by-country. In focusing on the senior tranches, the ECB may find itself competing with the other investors. It is the riskier tranches, like the mezzanine tranche, which would likely have greater impact.

However, the ECB's request that government's guarantee this so that the ECB does not face a potential loss is running into obstacles, including by the Bundesbank's Weidmann who resists efforts to further transfer risk from banks to taxpayers. A news wire survey found a consensus expectation for the ECB to buy 250 bln euros of ABS securities and 160 bln euros of covered bonds.

The implication of these forecasts is that the ECB falls short of boosting its balance sheet as much as Draghi wants. The risk is that softer participation in this week's TLTRO will fan expectations for either more generous terms of the remainder of the TLTRO or a more liberal ABS/covered bonds effort, or new bond purchase program (QE proper?)

We suspect this will be a bit self-reinforcing. Strong banks that have paid back the LTRO borrowings have no compelling economic need to take on ECB money may prefer to wait for the December opening to decide whether to participate. The weak banks and those with LTRO borrowings still to pay will likely be more active participants. This risks creating a stigma, which was successfully avoided with the LTRO.

Weak participation could weigh on the euro as the market anticipates stronger official action. Expectations of a sovereign bond purchase program could see the long end of the bond curves perform better. Stronger participation could help fuel an upside correction in the euro. To the extent the funds would be used to buy sovereign paper, in order to minimize maturity mismatches, the 2-3 year tenor may be supported. However, partly in anticipation of this, 2-year yields are already negative in 6 eurozone countries today, and another two are straddling the area.