ECB Ready to Offset Banks’ Accelerated LTRO Payback

The European Central Bank is poised to offset any acceleration in emergency loan repayments by the region’s banks to ensure reduced liquidity doesn’t undermine its monetary policy.

Two-year German yields climbed to a 10-month high as traders increased bets in January on higher money-market rates after lenders started repaying money disbursed by the central bank’s Longer-Term Refinancing Operations.

Banks have pledged to return 145.6 billion euros ($195 billion) of the initial 489 billion euros of three-year funds, leaving about 510 billion euros of excess liquidity, according to analysts at JPMorgan Chase & Co. ECB President Mario Draghi said last week he expects at least 200 billion euros to remain outstanding, suggesting a bigger return of funds would prompt renewed efforts to ease monetary conditions.

“The ECB will be monitoring this, and if there is pressure on front-end rates, the ECB would take action to alleviate that,” said Mark Dowding, a senior fixed-income manager at BlueBay Asset Management in London, which oversees $47 billion. “It may be a cut, it may be additional policy action on collateral or other measures to ensure that there’s enough liquidity in the system.”

Rising Yields

The yield on two-year German notes rose to 0.32 percent on Jan. 28, the most since March and up from minus 0.013 percent at the start of the year. It was 0.19 percent today, compared with an average of 0.08 percent over the past 12 months.

The central bank flooded financial markets with two tranches of three-year loans to avert a so-called credit crunch after banks stopped lending in Europe’s sovereign-debt crisis. The first opportunity for financial institutions to return money from the second tranche of loans, which amounted to 529 billion euros, is Feb. 27.

While the ECB doesn’t provide details of which institutions are returning the loans early, some companies have announced how much they’re handing back. Banco Santander SA said Jan. 31 that it returned 24 billion euros of the loans and Banco Bilbao Vizcaya Argentaria SA gave back 8 billion euros.

The euro reached $1.3711 on Feb. 1, its highest level since Nov. 14, 2011. It rose 0.4 percent to $1.3453 today.

Three-month Euribor, the rate at which banks say they can borrow euros, is 0.226 percent, according to data from the European Banking Federation. It climbed to 0.234 percent on Feb. 1, the most since September.

Futures Rates

The implied yield on the three-month Euribor futures contract expiring in December 2013 has climbed to 0.43 percent from 0.25 percent at the start of the year, according to data compiled by Bloomberg. The implied rate rose to 0.61 percent on Jan. 28, the most since July 2.

“If the amount of the second tranche paid back is a similar proportion to the first, that would be in line with what the market’s expecting,” said Elaine Lin, a strategist at Morgan Stanley in London. “If it’s a bigger number, we could see a move up in money-market rates. Draghi said in the press conference, that he knows that there will be 200 billion euros in the system. For now, the market has taken the view that the ECB is ready to act if the liquidity falls below this.”

Any stress in money markets would probably result in banks increasing borrowing at the ECB’s three-month refinancing operations, something that hasn’t happened yet, said Richard McGuire, a strategist at Rabobank International in London.

Tighter Conditions

“There was no evidence that stress was shifting from one ECB window to another,” McGuire said. “What the ECB does now depends on the market reaction. To the extent that the euro strengthens and the front end of the German curve rises as the ECB balance sheet shrinks, then that delivers a de-facto monetary tightening, and may prompt the ECB to open the door to a lower refinancing rate.”

An index compiled by Rabobank, based on European Commission data, shows monetary conditions tightened in the three months through the end of January at the fastest pace since the euro began in 1999, McGuire said.

“We will closely monitor conditions in the money market and their potential impact on the stance of monetary policy, which will remain accommodative with the full-allotment mode of liquidity provision,” Draghi told reporters at a press conference on Feb. 7 after the central bank held its key interest rate at 0.75 percent. “When we estimate repayment for the second LTRO, we are left quite persuaded that the excess liquidity will be well over 200 billion euros, confirming the monetary policy stance as being accommodative.”

Implicit Promise

Banks paying back the loans is a positive because it reflects an improvement in financial market confidence, according to Draghi.

“There was perhaps something implicit in Draghi’s statement,” said Mark Wall, Deutsche Bank AG’s London-based chief euro-area economist. “There may be a hint that, were money market conditions to drift away from the ECB’s desired monetary policy stance, they may be willing to take action and reengage in policies that they engaged in earlier in the crisis.”