FOREX TRADING

European money markets have been nervous this week ahead of the expiry of the 1Y LTRO. Market conditions have worsened. The 3M EONIA has risen to the highest level since July 2009, and there has been elevated volatility in short dated EONIA on worries that weak European banks may have difficulties securing liquidity.

The ECB 12-month long-term refinancing operation (LTRO) conducted in June 2009 (EUR442bn) expires on Thursday, 1 July. The LTRO is planned to be financed by two new ECB operations: (1) a three-month LTRO, which is announced today; and (2) a six-day fine-tuning operation, which serves as a bridge facility between the 1Y LTRO and next week’s normal seven-day main refinancing operation (MRO). (See overview of operations in table on page two.) As the 1Y LTRO matures and with the ECB sticking to its weekly MROs and 1M and 3M LTRO, the average duration on liquidity should decline significantly.

Current excess liquidity is around EUR365bn, which should decline to EUR-77bn when the 1Y LTRO worth EUR442bn matures. Going forward, we expect excess liquidity to be well below recent levels, since healthy banks are able to get funding at cheaper rates in the market compared with one year ago. However, the more troubled Southern European banks are still likely to find incentive to draw on ECB facilities.

Key factors to watch will be the accumulated size of the roll and the allocation between the two new operations. Since the fall of 2009, an excess liquidity position of around EUR50bn has secured EONIA rates fixing close to deposit rates (around 0.30- 0.35%). If this condition still holds, then around EUR127bn should be rolled to keep EONIA rates stable. Most of the amounts are expected to be rolled over in the 3M LTRO since it would allow another 3M roll in September.

It difficult to judge the overall size of the roll in the coming days. Most market watchers expect a roll of around EUR250-300bn, which is not unfair in our view.

If excess liquidity falls below EUR50bn (implying a roll well below EUR127bn), it could push EONIA rates higher as it would be a sign of less stress in the money markets. This would increase expectations that the ECB restores its exit strategy in Q4 10. A risk scenario, which we however find unlikely, is that the ECB could be forced to lower its main refinancing rate to push down EONIA rates.

If the roll becomes very large, say above EUR300bn, then it would ensure a large liquidity surplus for the coming months and indicate large vulnerabilities in the financial system. This is likely to push down rates in the very front-end but lead to more market nervousness and tensions in money markets at longer maturities.

The ECB has been reluctant to scale up its bond purchases recently. Yesterday the ECB aimed to sterilise EUR55bn of liquidity created by the bond purchases. But the one-week fixed term deposit auction only saw bids of EUR31.9bn and at a high rate (0.54%) compared with last week (0.4%). With an outlook for less excess liquidity it could become more costly and difficult for the ECB to sterilise its bond purchases.