Will the Next Leg of the European Crisis Begin on January 30?

January 30 is an important date for European banks and for the euro system as a whole. The day could end up passing like any other day, but it could also spark a reversal of months of improvement in credit markets, sending the continent back into the depths of the crisis. Why you may ask? The answer is four short letters...

They are LTRO... or rather the lack thereof, because of January 30, banks can begin to repay the Longer Term Refinancing Operations, the three-year, fixed rate loans through the European Central Bank which helped to unfreeze European credit markets in the beginning of 2012. However, as banks start to repay these loans, the situation in Europe could worsen substantially.

Chances are that most banks will not pay back the loans yet because they have simply been so profitable in the carry trade that ECB President Mario Draghi set up for them. Essentially, banks would borrow at 1 percent for 3 years and take the proceeds and purchase peripheral government bonds, mainly those of Italy and Spain. Combined with the Outright Monetary Transactions program launched over the summer, the new rounds of liquidity have helped to unlock credit markets, all the while being profitable for banks.

If anything, it would only make sense for the largest European banks, mainly those in France, Germany, and Italy, to refinance at this stage. Credit spreads have fallen over the past 12 months and now the biggest banks may be able to borrow for less than 1 percent in the open market. If this is the case, they could simply cancel the loans through the LTRO and borrow on the regular market cheaper to replace that financing. Smaller banks, who have to borrow at higher rates and generally have to post more collateral in the repo market, would not see such an advantage and probably not refinance in the current environment.

There is a risk that the rapid repayment of loans to the ECB causes fear in European credit markets, causing them to start to seize again. Should this be the case, Italian banks would be the most vulnerable. Italian banks took up the largest amount of the LTRO's and could face collateral calls from the ECB if others start to repay loans early and credit spreads widen. Simply, if too many banks start to repay the loans early, it could cause credit spreads to widen forcing the ECB to call more collateral from the smaller, weaker banks. This in turn would weaken the European credit markets, making the situation in Europe worse.

Investors should watch EONIA rates, short term borrowing rates in Europe, as well as the FRA/OIS spread, a key measure of the cost of borrowing dollars for European banks. Should these spreads tick higher, it would signal weakness in the banking system and potentially the next leg of the crisis. And remember, the ECB has already pledged to supply trillions of euros in cheap funding, pledged to do everything to maintain the euro, and simply pledged to monetize debts of troubled nations. Thus, what more could they do if the crisis worsened again?