ECB: Duration on Liquidity Falls Significantly

The ECB's 12-month long-term refinancing operation (LTRO) conducted in June 2009 expired today, and this reduces the liquidity position by EUR442bn. The expiry is financed by two new ECB operations. Yesterday, EUR132bn was allocated in the three-month LTRO, and today EUR111bn was allocated in a six-day fine-tuning operation. The total roll is therefore EUR243bn and this reduces the overall excess liquidity by around EUR200bn.

The total roll is close to the expected EUR250-300bn. However, the composition was a surprise, as it was expected that the bulk of the roll would be carried out in the 3M LTRO rather than the six-day fine-tuning operation. Most likely, some banks would prefer the flexibility to roll every week rather than locking themselves in for three months. This is possible as the ECB maintains full allotment at the weekly main refinancing operations (MRO) until mid-October, possibly longer. Furthermore, there is some talk in the market that the ECB could introduce a 6M LTRO at its policy meeting next Thursday, 8 July. If banks have already locked in for another three months, they cannot utilise a six-month facility.

A consequence of large usage of the six-day operation is a significant shortening of the average duration on liquidity. This implies higher funding risks going forward, hence higher risk premia. For instance, EUR274bn will mature next Wednesday, 7 July, compared with the EUR151bn that matured yesterday.

Market reaction: When the result of the 3M LTRO was announced yesterday, the market reaction was positive, as it was interpreted as a sign of health that fewer banks than expected needed to use the 3M LTRO. 3M EONIA and two-year German government bond yields rose by 4-5bp on lower excess liquidity and rising expectations that the ECB could continue its exit strategy during Q4 2010. Today, there has been some reversal of these movements. 3M EONIA continued to increase ahead of the announcement of the auction, to 52bp. However as the six-day finetuning auction saw large demand these rates fell again to 47bp and are now only 2bp higher than yesterday morning. Two-year German yields have also declined, but only marginally to 69bp, which compared with 55bp yesterday.

Going forward: We do not expect the decline in excess liquidity to be enough to push EONIA fixings higher in the coming weeks and maybe months. However, as duration on liquidity is reduced significantly, we expect a considerable risk premium in the money market to imply a relatively steep EONIA curve. This premium could decline a little over the summer if there are no major negative events.