Friday's announcement that on January 30th, 278 European Banks have chosen to repay €137.2bln in funds that they borrowed from the ECB in the first of the LTROs, spooked the European interest rate markets.
Why I am not so sure. There are little risk free assets you can buy above the rate, 0.75%, at which these banks are borrowing from the ECB at. So it would make sense to repay it if you could.
The removal of a much larger than expected, €75bln-€100bln had been predicted, of the excess reserves most banks have built up over the past year, has meant that short-term interest rates rose significantly on Friday.
3 month Euribor futures for December sold off 17c in the 90 minutes after the announcement- effectively saying that 3mth Libor will be fixed at 0.60% in December 2013 as opposed to 0.43%. The market had been pricing in some removal of liquidity from the LTRO injections of last year, but the huge amount repaid at the first opportunity means that monetary conditions in the Eurozone will have tightened quicker and by more than had been expected in the first quarter of this year.
The market reaction was to see 2 yr German Bund yields rise 9bp to hit 0.28%, at the beginning of January yields were close to zero as some of the excess reserves were parked in the liquidity and safety of German Bunds. The knock-on through the German bund market saw 5yr yields rise from 0.65% to 0.75% and 10yr yields rise 6bp from 1.59% to 1.65%.
This sharp sell-off dragged UK and US bond yields higher as well. But oddly peripheral bond yields held in and Spanish and Italian yields even fell.
Why this occurred is anyone's guess.
I would have thought that if the signs are there that monetary conditions are tightening in Europe than Risk assets, and in particular the peripheral bond markets, would suffer the most. Of course the money markets are still pricing in a rate cut from the ECB, sometime this year, with the 3mth Euribor curve for 2013 still below the official repo Rate of 0.75%, but with less LTRO money sloshing around at that 0.75%, higher yielding riskier assets will come under the most pressure.
What of course is now more than likely is that the ECB will have to signal that they will cut the Repo rate probably at the March 7th meeting. That signal will come at the next meeting on Feb 7th. That will mean a lower Euro/US$ rate. Something that is essential for the Eurozone economies.
The sell-off in interest rate markets, which comes amid uncertain economic news, is leading to yet again a rise in interest rate implied volatilities. the large swings in rates over the past few months is also seeing rises in historical volatilities and justifies the move higher in implied volatility.
So uncertainty is growing even more here. That continues to show that risk markets are continuing to show complacency. Just look at the tightness of credit spreads in the US in relation to the continual high levels of interest rate implied volatility. We saw the same at the same time of the year in 2010 and 2011.
And there are still few signs to signal that anything is justifying an increase in US Interest Rates apart from sentiment.
The back-up in yields in US 10yrs has not been led by rises in inflation expectations.
And there are few signs that commodity prices will change anything in the inflation markets.
Yes, I can see that copper prices have been on an upward trajectory, and that has been moving front-end inflation expectations modestly higher, but longer dated inflation expectations are anchored. The rise in copper has been put down to an improving US Housing market and restocking in China. Neither of these to me look set to continue much longer and I would expect Copper prices to begin to decline along with other base metals. So the rally in Copper since November is now looking to peter out .
I pointed out before that any sell-off in US Treasuries and a move to higher yields because of global growth expectations should be felt by other Dollar bloc countries first. But here 10yr yields in both Canada and to a slightly greater extent Australia are performing better. Canada has outeperformed the US by 10bp in the past two weeks and Australia by 13bp. That is not consistent with a risk-on rally forcing US yields higher. Canada outperformed the US by 4bp on Friday alone.
And some risk aversion continues- Gold priced in Euros has fallen 3% so far this year but is still in demand and if risk apetite in Europe was so strong as some will tell you then it should be closer to €1100/toz. It is not because there remains significant worries over the European banks. The LTRO repayment will show which banks are able to stand alone from government and central bank aid and which are not. 523 banks took money in the first LTRO, and 278 found that 0.75% for the next two years was an uneconomic borrowing rate. So 245 European banks are not in that position of strength.
Euro Gold shows that retail investors are more cautious than institutional credit investors.
With the potential for a weaker Euro and rising bank credit risks in coming weeks I would suggest that Euro Gold may well have bottomed for the time being.
So for the time being I do not see a reason to change strategy. Yes, being ultra long duration has not worked at all this year, but the reasons for holding those positions have not changed.
So I would expect that the markets should move back to lower yields and risk markets will eventually be repriced.