LTRO Expectations Weaken Dollar, Send Risk Higher
On Tuesday, the US dollar index declined roughly 1% as nearly all risk assets rallied.
The Dow Jones Industrial Average gained over 250 points in early trading, while gold and oil moved sharply higher.
The move may have been motivated by traders' expectations, as the European Central Bank is set to unveil details of its 3-year bank funding operation—LTRO—on Wednesday.
The plan gives additional capital to European banks, which may result in a reduction of sovereign borrowing costs. With the capital provided by the LTRO, the banks could opt to purchase the debt of distressed Eurozone sovereigns, driving down yields and bringing some relief to the Eurozone crisis.
Yet, bullish traders may fall victim to an unfortunate surprise. Many market commentators have criticized the plan as amounting to little more than a shell game. Bill Gross of PIMCO tweeted on Monday that it amounted to nothing more than Europe shifting funds from one hand to the other.
Even the President of the ECB—Mario Draghi—downplayed expectations for the operation when he addressed European lawmakers on Monday. Benzinga Pro covered Draghi's address on Monday, and alerted subscribers to Draghi's remarks in real-time.
The fear is that European banks could not participate with the plan. The banks are not obligated to purchase the debt, and in fact, if they do not act together, individual banks purchasing the debt on their own could quickly open themselves up to market speculation about their solvency.
Even if the plan does work, challenges remain. Ultimately, it does little to solve the root of the problem—too much debt—and only gives the sovereigns a bit more time to get their houses in order.
Market participants have seen this tactic used repeatedly for the majority of the year, as the Eurozone has seemingly kicked the can down an endless road.
At any rate, bearish investors may have been killed on Tuesday in the wake of the market's tremendous rally, and the euphoria may linger into future sessions.
For its part, the euro gained against the US dollar, as fears that the currency could dissolve may have receded. If the operation fails to stem the crisis, traders may anticipate a rally in the dollar while the euro trades lower in future sessions.
Traders who believe that the LTRO will have a calming and positive effect on the markets may consider:
- Go long US equities. The market rallied sharply early Tuesday, but could continue to rally on Wednesday and into later sessions, particularly if yields on sovereign bonds trade lower.
- Take a stake in in gold. Traders can do this by playing the futures market or with an ETF, such as the SPDR Gold Trust (NYSE: GLD). Gold could rally if traders see the actions of the ECB as inflationary. If the ECB is bailing out sovereign nations through its banks, it could weaken the euro and send gold higher.
Traders who doubt that the LTRO will have anything but a short-term effect on markets may consider alternative positions:
- Short the markets. This may be dangerous given the possibility of a rally, but after such a strong move to the upside on Tuesday, some kind of pullback may be expected.
- Run to cash. The US dollar has strengthened on days when risky assets have sold off, and could do so again if the markets trade lower.
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