Beware of LTRO early repayments warn Lombard Odier’s Stephanie Kretz and Karen Guinand
Stephanie Kretz and Karen Guinand at Lombard Odier’s investment strategy team for private banking have warned that early repayment of LTRO loans by eurozone banks may not necessarily be positive.
Last week saw eurozone banks start to repay loans extended a year ago by the European Central Bank (ECB) through the Longer Term Refinancing Operation (LTRO). Investors generally viewed this as a positive sign that “European money markets are healing and banks are more confident about their access to market funding”.
Our take is more cautious for a number of reasons – chief of which the resultant relative shift in central bank policy stances.
Note first that repayments go hand in hand with a shrinking of eurozone banks’ balance sheets. In effect, banks are repaying LTRO loans by aggressively running down excess reserves held in their current account facilities at the ECB – down to €377bn from €560bn mid-January – extending the sharp €2.1trn drop in total assets of the eurozone banking system since the May 2012 peak.
In turn this means that credit to the private sector is contracting. At the end of last year, loans granted to eurozone residents had fallen by €686bn from their June 2012 peak. For just the household and non-financial corporate sectors, the drop was €234 bn (2.3%) – mostly concentrated in the PIIGS (down €172bn from June to December 2012, or 8.8%, of which half in December alone). Given the still vastly excessive leverage of eurozone banks versus their Tangible Common Equity (TCE), this process has much further to run, implying that tight credit conditions are here to stay.
Another key consequence of the repayment of LTRO loans by eurozone financial institutions is the reduction of the ECB balance sheet, at a time when its US and Japanese counterparts are doing just the reverse. The fact that the ECB is going against the tide, with a balance sheet that has contracted 5.6% from its peak while the US and Japan have committed to adding liquidity to the tune of 8% and 20% of GDP respectively this year, is putting upward pressure on the euro – obviously not a welcome development for eurozone economic growth in general, and for German exporters in particular.
Continued repatriation of overseas assets (down 6% over the past 6 months) by eurozone banks is adding to the upward pressure on the single currency. While we ultimately expect the ECB to re-join the QE trend, which would add more fuel to the QE (and associated FX) war later this year, the immediate contraction of liquidity in Europe, combined with investor complacency bordering on euphoria, and a number of red flags in the US (stretched valuation, peak margins, relative debt/equity issuance, upward pressure on bond yields) leads us to re-emphasize the importance of protecting downside risks in portfolios.