Draghi Hints At New LTROs In Jerusalem Speech as Spanish, Italian Stocks Gain
European Central Bank President Mario Draghi overnight hinted at a further extension of the longer-term refinancing operations (LTROs) that helped to un-freeze European credit markets back in late 2011 and early 2012.
On December 21, 2011, the ECB made available to European banks 3-year one percent loans totaling about $640 billion that European banks used to buy peripheral European debt, staving off further crisis.
President Draghi gave the first strong hint overnight that the LTRO program, or at least its current iteration of 3-year term loans, overnight in a speech in Jerusalem. He noted that to address financial fragmentation and the breakdown in the monetary policy transmission mechanism, the ECB could increase the range of accepted collateral, increase the scope of policy outside of traditional policies, and " further contribute to alleviating the banks' funding uncertainty by providing banks with assurance that they could rely on our refinancing operations for extended periods."
The last line is key: Draghi had hinted before that the European Central Bank could offer a new round of 3-year LTROs, but this is the first concrete reference to such a policy. Although the OMT has created lots of resistance for conservative members of the ECB due to it potentially violating the ECB's mandate, the LTROs are well-within legal boundaries and could be a way for Draghi to fight the next crisis.
The previous round of 3-year LTROs saved the eurozone. A broad measure of financial risk in the eurozone and the health of short-term funding markets is the FRA/OIS spread. In late 2011, the spread, which is a measure of confidence in the interbank lending market, reached near peak levels not seen since the height of the financial crisis in 2008 above 40 basis points before retreating to single digits, where it averages.
Draghi, in his speech, is most likely indicating that such measures are not coming imminently at the next meeting of the Board of Governors. Rather, Draghi may be indicating that, should another round of the crisis flare up or should the OMT be declared illegal in the German Constitutional Court, then more LTROs could be the first action of a crisis response.
Limitations of Policy
Draghi also spoke to the limits of monetary policy in his speech. "The first is positive and refers to the effectiveness of central bank actions at the margin – for example, when interest rates are close to zero. I will not dwell on the first dimension because I do not think that we are materially challenged in our ability to deliver our objective of price stability by the low level of interest rates."
However, Draghi is much more concerned about the negative effects of monetary policy, mainly the risk of "blurring the boundaries of central bank policy." Draghi approached the topic through the framework of the economist Marvin Goodfriend, which divides policy into traditional monetary policy, credit policy (or the mix of government and corporate securities on the bank's balance sheet), and interest on reserves policy.
"Goodfriend argues that all three categories have fiscal implications. And he states that credit policy and interest on reserve policy involve the use of public funds in a way that may imply an allocative role – and which may therefore blur the respective roles of the monetary and fiscal authorities. Does the fact that our operations entail some credit risk on the balance sheet of the central bank imply a violation of our ordoliberal principles? Does it imply that the ECB policy interferes with credit allocation? My answer is no."
Draghi lastly spoke about the continued efforts for reform in the eurozone, specifically commenting on the banking union and broad European banking supervisor. He said that, although programs such as the OMT have been effective, reforms and the continued adjustments at both the country and euro area level have been crucial to the easing of crisis tensions in the eurozone.
"Preparations for single supervision at the ECB are advancing, and naturally we are working closely with the relevant national authorities. Five work streams are underway: first, on mapping the euro area banking system to identify systemically important banks; second, on the supervisory model to be adopted, which is most likely to be centred [sic] around joint supervisory teams; third, on supervisory data reporting; fourth on legal issues; and fifth, on the asset quality review that we will undertake prior to taking any bank under supervision."
Peripheral Stocks Pop
Shares of peripheral markets who would see the biggest boost from a new round of LTROs, mainly those of Italy and Spain, gained on the news. Spain's Ibex 35 Index rose 0.58 percent with financials strong in the index. Meanwhile, Italy's FTSE MIB Index gained 0.51 percent, also on strong gains from financials.
Peripheral markets were the biggest gainers from the previous round of LTROs as struggling banks were able to get cheap loans and then invest them in sovereign debt of their respective nations in a massive carry trade. Spanish 10-year bond yields ticked down one basis point on the news to 4.57 percent while 2-year bond yields declined two basis points to 2.19 percent. Italian 10-year bond yields fell one basis point to 4.26 percent while 2-year bond yields rose 4.6 basis points to 1.97 percent.
New Easing Catalysts?
The LTROs are not traditional monetary policy and would not be used to combat slowing inflation and weak growth. That is the realm of traditional balance sheet monetary policy. Rather, the LTROs are crisis-fighting measures.
A flare-up of the financial crisis in Spain or a return to fiscal worries in Italy would surely warrant another round of LTROs. Also, if French banks became a source of worry, it would surely mean that the ECB would step in to alleviate financing worries.
You can read President Draghi's speech in full here.
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