Investment Research General Market Conditions 26 August 214 ECB easing will it work? #2 Liquidity and money market rates We expect the TLTROs will boost liquidity. However, the amount of borrowing limits is unknown as it depends on net lending behaviour we list four different scenarios that give an upper target ranging from EUR45-1.35bn. The liquidity is spread over the eight different TLTRO auctions and looking at our scenarios, the potential take-up is biggest in TLTRO 3 and to some extent TLTRO 4 (Mar-15 and Jun-15) and fading from then on. This follows as net lending benchmarks are most generous in the first year. Although there is a potential mismatch between the repayment of the outstanding LTRO borrowing and available funds across countries from the first three TLTRO auctions, we see less prospects of falling off a liquidity cliff as the regular MRO auctions have previously been used to bridge liquidity operations. We have estimated a relationship between the level of excess liquidity and Eonia and conclude that although it most likely requires additional liquidity to get Eonia below.% (or further ECB cuts), the market implied expectations for excess liquidity (around EUR2bn in June 215) is in the lower end of our expectations. We share the view of Mario Draghi who has repeatedly described the TLTROs as a very attractive program. Hence, we expect banks to demand the TLTRO loans and that liquidity in the euro system will increase but the big increases will most likely happen with the 215 operations. ECB easing will it work? ECB s easing measures revisited, 25 August Liquidity and money market rates, 26 August Potential for carry trades, 27 August Impact on growth and inflation, 28 August ECB s policy going forward, 29 August Four scenarios for net lending give total TLTRO availability of EUR45-1.35bn 1,6 1,4 1,268 1,356 1,2 1, 8 895 1, 6 4 444 2 Half the delevering trend Flat net lending Draghi "up to 1tn" Model on credit growth TLTRO 1&2 TLTRO 3-8 Continuation of trend Analyst Anders Vestergård Fischer +45 45 13 66 41 afis@danskebank.dk Senior Analyst Pernille Bomholdt Nielsen +45 45 13 2 21 perni@danskebank.dk Assistant Analyst Andreas Haldrup Björnsson abjr@danskebank.dk Important disclosures and certifications are contained from page 9 of this report. www.danskeresearch.com
How much liquidity and when - four different scenarios TLTRO 1+2 in September and December 214 availability is determined Estimating the available amount of liquidity in the TLTRO 1-2 auctions is straightforward as it has already been settled with 7% of the outstanding amount of eligible loans, totalling close to EUR4bn (see paper #1 ECB s easing measures revisited). In the scenarios we consider below, the distribution between TLTRO 1 and 2 is arbitrarily set to half of the amount in each auction (EUR2bn); we may see a larger take-up on the first because of the earlier access to cheap funds, though it may also be later as banks need to finish their applications and maybe prefer to wait for the results from the ECB s Asset Quality Review and stress test to be released in the second half of October. All in all, we do not believe that the exact distribution between TLTRO 1-2 will be that decisive for the overall effectiveness of the programme. However, a low September take-up could push down expectations for the December auction and thereby affect market pricing of liquidity and further policy moves. TLTRO 3-8 determined by net lending developments Turning to TLTRO 3-8, the total amount of borrowing limits is unknown as it depends on net lending behaviour from May 214 and up to the auction in question. Below we list four different scenarios for the potential development in these TLTROs in order to quantify the maximum amount available. It should be noted that we attempt to estimate the maximum potential uptake of the TLTROs for different scenarios and that everything but 1% participation from euro zone banks (an utopian scenario) would mean a somewhat smaller realised take-up. In the left hand chart below, we show the actual development in TLTRO eligible lending, which has already been released (the fully coloured markers), as well as four possible future trajectories (all excluding the model on credit growth calculated on a country level and aggregated). The chart on the right hand side shows the maximum amount of borrowing to be taken out for the different scenarios, which are: 1. A continuation of the deleveraging process seen in the past 12 months, but with half the speed - i.e. EUR7bn/month on average, compared to a rate of EUR14bn/month of deleveraging in the benchmark period (calculated on a country level with periphery banks having the largest decline in lending). 2. Zero additional net lending over the total period of the TLTRO, meaning that banks maintain the outstanding loan amount as it was per April-14. Four different scenarios for TLTRO eligible lending... 6, 5,95 5,9 5,85 5,8 5,75 5,7 5,65 5,6 5,55 5,5 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 TLTRO eligible lending Lending since May-14 Continuation of trend Model on credit growth Flat net lending Half the deleveraging trend... give TLTRO availability of EUR4-1.35bn 1,6 1,4 1,2 1, 8 6 4 2 444 Half the delevering trend 895 Flat net lending 1, Draghi "up to 1tn" 1,268 Model on credit growth TLTRO 1&2 TLTRO 3-8 1,356 Continuation of trend 2 26 August 214 www.danskeresearch.com
3. Our euro area credit demand model, which estimates potential uptake using forecasted investments based on our in-house forecasts for 214-216 (see Box 1 below for model specifications). 4. A continuation of the average trend after the benchmark period ended in April-14 (i.e. the average increase in net lending between the two available data points from May and June, July s MFI data will be available on Thursday 28 August). One thing worth noting about the listed scenarios is that they overall give support to Draghi s initial claim of up to EUR1trn, though the estimates are indeed very wide ranging. The lowest scenario yields a total liquidity available not much above EUR4bn, and looking at the two last scenarios, a continuation of the recent trend and the credit demand model, the boost to liquidity becomes sizeable and including the TLTRO 1-2 both of the scenarios ends with total liquidity well above EUR1trn. This illustrates and quantifies the point that the developments of net lending are crucial for a big liquidity effect from TLTRO 3-8. Box 1: Euro area credit demand model We have taken a simple approach in estimating a credit demand model and we have based it on the assumption that demand for credit is dependent on the economic prospects together with the price of credit. For the latter we use the ECB s composite cost of borrowing indicator for Non- Financial Corporations (NFCs), while our in-house forecast for GDP growth and investments in the euro area reflects the economic outlook. However, in running the regression both cost of borrowing and GDP growth is insignificant, and the model for loans to NFCs simply include a lag and the outlook for growth in investments. Note that we assume lending to NFCs is a constant share of total eligible lending. In the model credit growth remains negative until May 215, but it declines at a slower pace than it has done since the beginning of 213. This results in a large amount of potential borrowing on the TLTRO due to the declining benchmark for the euro area until April 215. The model is a pure demand model and does not include any supply side aspects. Hence, it is likely to overestimated actual growth in lending to NFCs if banks are in liquidity shortage, face capital constraints or perceive the credit risk as higher than the expected return on lending to NFCs. Especially capital constraints are likely to have limited lending supply during the latest years, but the ECB s Bank Lending Survey for July showed that banks eased credit standards to loans for enterprises for the first time since 27 while they also expect to ease credit standards. This suggests that supply constraints will play a smaller role going forward. However, Standard and Poor s conclude that euro area banks still have a capital gap to a tier 1 capital ratio of 11% and in light of this the credit demand model, could overestimate actual lending for some time. (For more about credit supply see our upcoming paper about impact on growth and inflation). Timing of liquidity availability big difference across scenarios Our set-up also allows us to answer the question on the timing of liquidity. Given our four different developments on net lending, we compare the aggregate availability seen in the charts below. The half deleveraging trend offers very little additional potential uptake after the first two TLTRO 1-2 auctions and even predicts early repayment, as net lending is below the 3 26 August 214 www.danskeresearch.com
benchmark in April 216 (for more on the TLTRO details about early repayments see paper #1 ECB s easing measures revisited). Looking at the flat net lending scenario, there is a significant uptake in TLTRO 3-4 auctions, after which the banks no longer qualify for further loans, but are able to keep the liquidity until maturity in 218. Evaluating TLTRO 3-8 across all scenarios, the general picture is that the potential uptake is biggest in TLTRO 3 and to some extent TLTRO 4 (Mar-15 and Jun-15), and fading from then on. The reason behind this is obviously the generous benchmark for negative net lenders during the first year, as they can continue deleveraging and still be eligible for the liquidity. Furthermore, the time leading up to the TLTRO 3 is the longest, giving a longer time to accumulate net lending compared to the following three-quarter periods. Potential excess liquidity - scenarios #1 & #2 Potential excess liquidity - scenarios #3 & #4 1,6 1,2 8 4 1,6 1,2 8 4 2 2 2 2 22 371 67 Half the deleveraging trend 124 895 Flat net lending Early repayment -225 444 Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 jun yy Sep 16 Total Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 jun yy Sep 16 Total 1,6 1,2 8 187 227 67 2 4 2 1,268 137 16 145 Model on credit growth Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 jun yy Sep 16 Total 1,6 176 63 63 63 63 1,356 1,2 527 8 2 4 2 Continuation of trend Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 jun yy Sep 16 Total Funding gap between the TLTRO auctions and the LTRO run-out As the current two 3Y LTROs mature 29 January and 26 February 215, banks which have not repaid the TLTROs in full face a need to roll into the TLTROs to fund their outstanding LTRO borrowing. The table below shows the outstanding amounts of the LTRO borrowing and available funds across countries from the first three TLTRO auctions (most relevant for bridging LTRO funds). The boxes marked with red indicate countries where the maximum TLTRO funds are not enough to cover the outstanding LTRO funds - in the middle for only TLTRO 1+2, and on the right hand side the red areas indicate countries where not even adding the TLTRO 3 is enough to meet the then expired LTROs. Note that the take-up in TLTRO 1 relative to TLTRO 2 does not matter for rolling over the LTRO debt, as these mature in January and February 215, after the TLTRO 1-2 settlement. Maturing 3Y LTROs and the coming TLTROs 1-3 Current 3Y LTRO* TLTRO 1 + 2 TLTRO 3 Initial size (Dec-11, Feb-12) Current Outstanding** Maximum possible take-up Half delevering trend Flat net lending Continuation of trend Euro Area 1,91 453 398 22 371 527 Germany 73 16 95 12 24 52 France 174 43 77 6 149 Belgium 4 14 1 4 2 Italy 268 171 75 48 95 91 Spain 315 15 54 92 183 151 Greece 37 1 1 7 13 Portugal 51 35 8 7 14 7 Ireland 79 17 8 8 15 Other EA countries 54 6 11 2 27 76 * Including 3m LTRO ** End July 214, data from national central banks balance sheet Source: Bloomberg, ECB, Danske Bank Markets 4 26 August 214 www.danskeresearch.com
LTRO 1 & 2 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Outstanding ECB easing will it work? #2 Looking at Italy and Spain, banks in both countries will not be able to cover the outstanding LTRO. Italian banks face the biggest challenge with still EUR171bn outstanding with only EUR75bn available in the first two auctions and an estimated amount between EUR48-91bn available in TLTRO 3 in our scenarios. Also, Spanish banks face risks falling short but only with a fairly short amount in the most pessimistic of the scenarios. Note that the credit demand model is not included in the table above as it doesn t allow for country specific estimates. However, looking at the euro area aggregate, it suggests EUR587bn available in total over the first three TLTRO auctions, which is more than sufficient to cover borrowing demands at the time of roll over. Still some EUR4bn of LTRO outstanding Regular MRO auctions bridged liquidity in June 21 EURbn 1,19 1, 8 6 4 137 75 25 37 18 14 9 4 22 19 28 58 7 6 43 32 18 389 29 37 12 2 Monthly Repayment Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets The countries in which banks are not able to match outstanding LTRO amounts with the first three TLTRO auctions do not necessarily face problems as the MRO facilities are still standing under the fixed rate, full allotment procedure. Hence, it allows the banks to get liquidity (given available eligible collateral) to cover LTRO repayments until further TLTRO allotments. Something similar was seen in June 21, where the repayment of some EUR44bn in 1Y LTRO was met with a corresponding increase in the weekly MROs (right hand chart above). Therefore, we are not overly concerned about any liquidity cliff with the maturity of the outstanding LTROs. How will excess liquidity affect Eonia fixings? The boost to liquidity should affect money market rates, an effect which we have already seen with record low Eonia fixings after the ECB announced it would suspend the sterilisation of the SMP purchases and introduced negative rates at the June meeting. To get an idea of how the coming TLTROs are going to affect short-term interest rates, we start by looking back at how past increases in excess liquidity have affected Eonia, and how the market is currently positioned with regard to the TLTROs. This requires estimating a relationship between excess liquidity and Eonia. Doing this we further show that the relationship between the Eonia and excess liquidity has shifted over time (see Box 2 below for a description of the method). We do not include data since June 214 in the estimation in order to avoid a paradigm shift since the introduction of the negative deposit rate, but in the upcoming paper we make a thorough analysis of how the negative deposit rate has changed front-end dynamics. The results are illustrated in the left chart below. As can be seen, the satiation point, at which Eonia is brought down to a level so low it no longer responds to further increases in excess liquidity has shifted upwards from about EUR125bn to around EUR225bn in the second estimation period. This implies heightened market fragmentation, as it takes 5 26 August 214 www.danskeresearch.com
Eonia in 1bp normalised corridor ECB easing will it work? #2 higher amounts of excess liquidity to meet interbank borrowing demand in the euro system without Eonia moving higher in the corridor. This suggests that we should expect it requires higher levels of excess liquidity from the current levels of around EUR13bn in order to get Eonia into negative territory. Model on Eonia in corridor and excess liquidity in two sub-periods 1 Market pricing of Eonia (ECB runs)....25%... and corresponding model implied level of excess liquidity 25 75.2%.15% Current MRO rate 2 15 5.1%.5% 1 25 Excess liquidity.% 5 1 2 3 4 5 Jan-8 to Jan-13 Jan-13 to Jun-14 -.5% Aug-14 Aug-15 Aug-16 22/8/214 25/8/214 Aug-14 Aug-15 Aug-16 22/8/214 25/8/214 Source: Bloomberg, Danske Bank Markets Source: Danske Bank Markets Source: Danske Bank Markets Using the found relationship for the latter period since Jan-13 and future ECB runs for Eonia we can work out how much excess liquidity the market is pricing in. However, that exercise requires a crucial assumption that the pricing of Eonia forwards reflect liquidity expectations and not future changes to ECB rates. With Draghi s comments at Jackson Hole last Friday (see Flash Comment - Draghi increases likelihood of further easing ), we have witnessed big declines in Eonia forwards consistent with expectations of further cuts in MRO and deposit rate. Therefore, we compare two curves: 1. Before Draghi s speech (22 August) with a low point of.% in Eonia forwards which backtracked with our model gives excess liquidity in the area of EUR15-18bn. 2. Yesterday (25 August) with a low point of -.3% yielding higher estimated liquidity expectations of just above EUR2bn. Although we acknowledge that using the Eonia curve after Draghi s speech has some methodological flaws due to the pricing of further ECB rate cuts, we think that both estimates of around EUR2bn are somewhat low compared to the potential size in the TLTROs. We can easily imagine a larger net liquidity injection than the EUR+7bn (from current levels around EUR13bn), which is consistent with the current pricing. Mario Draghi has repeatedly described the TLTROs as a very attractive program, thus trying to alter the at least once attached stigma (that was related to previous longer ECB operations). Furthermore, we have for some time argued that the introduction of negative rates has created a hot potato effect, and thereby causing the same amount of excess liquidity to push down rates even further. Tomorrow, we ll look deeper into these factors and how they may have caused yet another shift in the excess liquidity/eonia relationship. 6 26 August 214 www.danskeresearch.com
Box 2: Market fragmentation and the Eonia Liquidity and the Eonia The dynamics of how the ECB rates transfer into Eonia has received much attention for some time with the volatility in excess liquidity. However, as the relationship between the two is suspected to have shifted over time, we estimate the relationship for two different sub-periods. We are looking at Eonia in the so-called normalised corridor in order to handle the shifting size of the ECB interest rate corridor (spread between MRO rate and deposit rate is currently 25bp has previously been up to 75bp in our data period). It assigns a value from to 1 with being the Eonia equal to the deposit rate, 5 the main refinancing operation rate (MRO) and 1 the rate on the marginal lending facility (MLF), with all rates in between translated linearly. The same method is used in ECB s Monthly Bulletin (January 214). Heightened market fragmentation For the estimation, we consider the below periods, in between which we expect a shift to have occurred: 1 Nov 28 1st period - Start of fixed rate, full allotment procedure 31 Jan 213 - Start of repayments of 3y LTROs 2nd period 1 Jun 214 - Last day of positive deposit rates Within these two periods, the turn-dates (end of month) are disregarded, as well as negative measures of excess liquidity, as both give rise to extreme Eonia rates not related to the general relationship. The relationship is estimated using a nonparametric local fit. 7 26 August 214 www.danskeresearch.com
LTRO 1 (Dec-11) LTRO 2 (Feb-12) LTRO 1 & 2 Total amount LTRO 1 & 2 Total repayment LTRO 1 & 2 Outstanding TLTRO 1 & 2 DB Estimate Eonia in 1bp normalised corridor ECB easing will it work? #2 What to watch? ECB policy rates (corridor) and Eonia Excess liquidity and Eonia in 1bp normalised corridor 1 75 5 25 Excess liquidity 1 2 3 4 5 6 7 8 Jan-8 to Jan-13 Jan-13 to Jun-14 Source: Bloomberg, Danske Bank Markets Repayment of outstanding 3Y LTRO MRO auction to bridge any liquidity gap 25 LTRO repayment/weekly 22 1 EURbn 1,19 2 19 8 15 1 11 1 8 8 1 6 7 5 4 5 4 3 3 3 3 4 4 4 3 3 4 3 2 1 1 2 2 2 1 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 11 13 6 4 2 489 53 63 389 MRO acts as buffer DB Estimate 246bn Weekly LTRO repayment Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets Euro area net lending developments 6, 5,95 5,9 5,85 5,8 5,75 5,7 5,65 5,6 5,55 5,5 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 TLTRO eligible lending Lending since May-14 Continuation of trend Model on credit growth Scenarios for liquidity distribution of the TLTROs 1,6 1,2 8 187 227 67 2 4 2 1,268 137 16 145 Model on credit growth Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 Jun 16 Sep 16 Total 1,6 176 63 63 63 63 1,356 1,2 527 8 2 4 2 Continuation of trend Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 Jun 16 Sep 16 Total Source: Danske Bank Markets 8 26 August 214 www.danskeresearch.com
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