Marketing Communication Fixed Income Watch TLTRO: bazooka or peashooter? Group Economics Macro and Financial Markets Research Aline Schuiling, Nick Kounis, Kim Liu, Joost Beaumont 10 September 2014 Take up of first two TLTROs set to be high: While the ECB announced new measures this month, the flagship policy it announced in June, the TLTROs have not yet even started to be rolled out. We will focus on the impact of the first two operations (set for September and December) in this note. The allowed take-up for the first two TLTROs for the eurozone as a whole is around EUR 400bn in total. There probably will be ample demand. The cost of the operations compared to other sources of funding is favourable for banks. We expect take-up of around EUR 325-350bn, with the majority in December. Impact on liquidity to be more modest: Although there might be some transitional effects, banks will likely use TLTROs to repay their LTROs or their existing sources of market funding, so excess liquidity in the banking system is unlikely to increase by much on a sustainable basis. However, there will be some increase in liquidity in the financial system more widely, to the extent that the TLTROs crowd out private sector investors, who might then put their funds into other assets. This equates to the amount of net new borrowing that there will be from the ECB of around EUR 100bn. This is relatively modest, but subsequent TLTROs next year will likely lead to a more substantial increase in the ECB’s balance sheet. TLTROs to reduce supply of bank bonds: We expect the large initial take up in the TLTROs to reduce the supply of bank bonds, which will lead to lower yields. We expect a significant drop in unsecured yield curves in particular, since these are the most expensive for a bank to fund, match the TLTRO duration, while these securities will not be bought by the ECB. Covered bond programmes are likely to be less affected. This means that the introduction of the TLTRO operations could ultimately lead to a spread compression between 0-4yrs senior unsecured and covered bonds. Carry trades relatively limited: If banks primarily use the extra TLTRO liquidity to substitute external funding, this would decrease the likelihood and potential size of structural and persistent carry trades. However, banks could have excess cash surpluses, as least temporarily, to invest, while adhering to the ECB’s TLTRO lending conditions. Government bonds and SSAs up to 4-years in core and semi-core countries would generally not yield enough, meaning that banks would need to move up the credit or maturity spectrum. Bank lending supported by broad-based package: Although the TLTROs on their own will not make the difference for the outlook for bank lending, they are part of a comprehensive package of measures by the ECB, including the comprehensive assessment of banks and the covered bond and ABS purchase programme. All these measures together are starting to look formidable. In addition, demand for bank loans is starting to recover. We expect a gradual recovery in eurozone bank lending in the coming quarters. 2 Fixed Income Watch - TLTRO: bazooka or peashooter? - 10 September 2014 Introduction Will there be a difference between September and While the ECB announced new measures this month, the December? flagship policy it announced in June, the TLTROs have not yet We expect the take-up to be larger in December than in even started to be rolled out. With the first of these operations September. The interest rate on the TLTROs currently is 10bp approaching later this month, we take a closer look at the likely higher than the interest rate on the ECBs LTROs (see box impact. We will focus on the first two operations (set for below). Therefore, banks that still depend heavily on LTROs September and December) in this note, and will look more will probably postpone much of the borrowing to the December closely at the remaining six (to be spread during 2015) in an operation. Moreover, some banks will probably prefer to wait upcoming publication. We assess the likely take-up, the impact until after the publication of the results of the ECB’s stress test on liquidity, the effects on bank funding markets and bond (‘comprehensive assessment’) and AQR in October and the markets more generally, and bank lending. results of the take-up in the September TLTRO. What is the likely take-up of the first two TLTROs? The allowed take-up for the first two TLTROs (TLTRO1&2) for the eurozone as a whole is around EUR 400bn in total. There probably will be ample demand. The lending conditions and interest rate level compared to other sources of funding are Figure 1 - Borrowing allowance TLTRO1&2, % GDP % GDP 5.5 4.5 favourable for banks, particularly for the countries in the periphery of the eurozone (see below). On top of that, the 3.5 allowed maximum take-up of TLTRO1&2 for most of the peripheral countries (Spain, Italy, Ireland and Portugal) and for Belgium is smaller than the amounts they currently have borrowed from the ECB via the two three-year LTROs, which 2.5 1.5 GR ES PT AT will expire in January and February 2015. Consequently we IT NL IE EZ FR FI DE BE Borrowing allowance TLTRO1&2 assume that these countries will take up the full available amount of TLTRO1&2, of EUR 155bn in total. For the other countries we have assumed that the take-up will be around Source: ABN AMRO Group Economics 75% of the total allowance. This means that our estimate for the total take-up of the September and December TLTROs lies Box: Technical details and modalities of the TLTROs in a range of EUR 325-350bn. The ECB will conduct eight targeted longer-term refinancing Table 1 - Borrowing allowance TLTRO 1&2 operations (TLTROs). According to the ECB these are designed to ‘enhance the functioning of the monetary policy EUR bn Country Allowed take-up TLTRO1&2 Current LTROs transmission mechanism by supporting lending to the real (end-July 2014) economy’. They will provide banks with term funding up to four years (all TLTROs mature in September 2018). The interest Germany 95 16 France 77 36 Italy 75 159 Spain 54 134 Netherlands 29 5 Austria 15 6 18 September and 11 December, respectively). The borrowing Belgium 10 14 allowance of TLTRO1&2 will be calculated on the basis of the Greece 10 1 outstanding amounts of loans to non-financial corporations and Portugal 8 32 households Ireland 8 16 purchase). The total allowance for TLTRO1&2 equals 7% of rate on the TLTROs will be fixed at the level of the ECB’s refi rate at the time of the TLTRO+10bp (currently 0.15%). TLTRO1&2: The first two TLTROs (TLTRO1&2) will be conducted in September and December 2014 (allotment date (excluding loans to households for house the outstanding amount of these loans at end-April 2014. Eurozone 398 381 (Sep 5) Source: ECB, national central banks, ABN Amro Group Economics TLTRO 3-8: In addition, six quarterly TLTROs will be conducted, starting in March 2015 and ending in June 2016. 3 Fixed Income Watch - TLTRO: bazooka or peashooter? - 10 September 2014 The extra borrowing allowance of these six TLTROs will be because some private sector investors will be crowded out. based on net lending to the non-financial private sector (excl. The increase in liquidity will be equal to the net new funds of mortgages) between the end of April 2014 and the reference EUR 100bn. This is relatively modest balance sheet expansion month of the relevant TLTRO. In case this amount of net compared to, for instance, the size of asset purchase lending is larger than a specified benchmark, a maximum programmes by the Fed, BoE and BoJ. For instance, the Fed’s amount of three times the difference between the benchmark QE-2 programme would be equivalent to EUR 400bn. and actual net lending can be borrowed. The benchmark for However, subsequent TLTROs next year will likely lead to a banks that have expanded net lending during the twelve more substantial increase in the ECB’s balance sheet. months up to 30 April 2014 is set at zero. The benchmark for banks that have reduced net lending during the twelve months Figure 2 - Excess liquidity and interbank rates up to 30 April 2014 will be calculated by extrapolating the Bp change in net lending during this twelve-months period until April 2015 (i.e. the benchmark declines). After April 2015, the benchmark will also be set at zero. EUR bn 800 40 20 600 0 -20 Mandatory and voluntary early repayment: If net lending by -40 a bank is below the benchmark in the period from 1 May 2014 -60 to 30 April 2016, the bank will have to repay all TLTROs in full -80 on 29 September 2016. Moreover, if a bank’s extra borrowings -100 in TLTRO3-8 exceed the limit determined by the benchmark it has to repay the difference on 29 September in a mandatory 400 200 0 09 10 11 EONIA minus refi rate (lhs) 12 13 14 Excess liquidity (rhs) repayment. Two years after each TLTRO, banks have the option to voluntary repay the allotted amounts in part or in full at a six-monthly frequency. Source: Thomson Reuters Datastream, ABN AMRO Group Economics Are there implications for interbank rates? How will the TLTROs impact liquidity? The short answer is no. Over the last few years, interbank The impact on the TLTROs on liquidity is not straightforward. rates have been driven by the level of the ECB’s policy rates, The large take-up we expect in the first two TLTROs both current and expectations of where they will be in the (concentrated in December) is unlikely to manifest itself one- future, and the amount of excess liquidity in the banking for-one in either higher liquidity in either the banking system or system. Given that we do not expect the first two TLTROs to financial markets more generally. We think that the banks in increase excess liquidity for any length of time, we do not think the periphery with large LTROs outstanding will essentially just that they will have significant effects on interbank rates. replace their LTROs with TLTROs. That means the net impact However, excess liquidity will increase due to the ECB on excess liquidity in the banking system of the TLTRO take- purchases of ABS and covered bonds. It is not yet clear how up by peripheral banks will be negligible, though there could be large these programmes will be, but we think they will total some short-term transitional effects. The same is true in terms around EUR 150bn. Given the rate cuts and the rise in excess of the impact on liquidity in financial markets more generally. liquidity, we are likely to see a further decline in interbank rates, though this is not being driven by the TLTROs. The situation is different for banks, largely in the north of the eurozone, which have little or no outstanding take-up of What is the TLTRO advantage in terms of funding costs? LTROs. These banks will essentially be borrowing net new The TLTROs will likely result in a decrease in bank funding funds from the ECB. This means that the central bank’s needs from markets in coming years. Consequently, this will balance sheet will expand by roughly EUR 100bn or 5%. reduce supply of senior unsecured paper and covered bonds, Despite being a net increase in ECB lending, this is unlikely to which would add to the negative net supply in these markets. increase excess liquidity in the banking system. This is This looks likely because the TLTRO is a relatively cheap because northern eurozone banks have a strong incentive to source of funding for banks. The 0.15% banks currently have replace existing sources of private sector funding (for more on to pay for TLTRO funding compares to current yields on 2Y this below) because it is at lower cost. There will however be senior unsecured paper ranging from 0.38% in the Netherlands an increase in liquidity in financial markets more generally, to 1.5% in Ireland, while the range is 0.6% to 4% in the 4Y 4 Fixed Income Watch - TLTRO: bazooka or peashooter? - 10 September 2014 tenor. So, the benefit in the 4Y maturity is between 45 bps and take up in TLTROs, will fully use the TLTRO in order to replace 385 bps. Needless to say, the yields differ by bank. their LTRO funding. This is true for banks located in Belgium, Ireland, Portugal, Spain, and Italy. What is more, banks in Figure 3 - TLTRO take up minus current LTRO these countries will be able to substitute LTRO funding with EUR bn TLTRO money only partly, leaving a gap that needs to be filled (assuming that they need to fully refinance LTRO funding). IT ES Table 3 - Yields of covered bonds (%) PT IE Country BE Maturity 2Y 3Y 4Y Germany 0.1 0.15 0.22 NL France 0.1 0.17 0.24 FR Italy 0.5 0.54 0.7 Spain 0.4 0.45 0.65 Netherlands 0.1 0.15 0.22 Austria 0.17 0.26 0.36 Belgium 0.1 0.21 0.35 Portugal 0.7 0.8 1.1 Ireland 0.33 0.4 0.55 AT GR DE -100 -50 0 50 100 Source: ABN AMRO Group Economics Table 2 - Yields of senior unsecured bank debt (%) Country Maturity Source: Bloomberg, ABN AMRO Group Economics 2Y 3Y 4Y Germany 0.45 0.55 0.7 More new issuance from the periphery? France 0.5 0.6 0.7 Theoretically, this could imply that these banks will start to Italy 0.95 1.0 1.15 Spain 0.68 0.88 1.0 Netherlands 0.38 0.46 0.6 Austria 0.8 1.0 1.2 Belgium 0.5 0.68 0.87 3.5 4.0 banks will start to increase issuance of covered bonds/senior 1.65 1.8 unsecured debt. Partly because they increasingly want to Portugal Ireland 1.5 Source: Bloomberg, ABN AMRO Group Economics issue more senior unsecured debt or covered bonds to fill this gap, although it is also well possible that they will switch to MRO funding. In case of the latter, the impact on other funding sources will be zero. However, we do not expect that these banks will fully turn to MRO funding, as this is short-dated funding rather than term funding. As a result, we think these prove that they have access to capital markets, but primarily due to the favourable funding conditions and the ECB’s The advantage versus covered bonds is less pronounced. In the periphery, banks can also in this case raise cheaper funding using the TLTRO, especially in the longer maturities. However, for (soft)-core banks, there is only an advantage from a 3Y maturity. Overall (and not surprisingly), the advantage is bigger for peripheral banks than those from the (soft)-core. But given that covered bonds generally carry a maturity of 5Y or longer, it is clear that there is a big incentive for all banks to participate in the TLTRO from a funding cost perspective. What will be the impact on bank funding needs? We can estimate the impact of the TLTRO on bank funding needs using our assumptions of the take up in the TLTROs (see above). We expect that the banks that currently have a larger amount outstanding in LTROs than they can potentially covered bond purchase programme. As such, supply of senior debt, and (especially) covered bonds, might well increase from the periphery (and Belgium). And less from the core? Looking at banks in the (semi) core countries, we estimate that their take up in the TLTRO will exceed that of the current amounts outstanding in the LTRO. As a result, we expect that, on balance, these banks will reduce funding on the wholesale markets, reducing issuance of senior unsecured debt as well as covered bonds. In total, we estimate that banks in the Netherlands, Germany, France, and Austria, will take up roughly EUR 160bn in the TLTROs, replacing around EUR 60bn of LTRO money, leaving a surplus of roughly EUR 100bn. Bloomberg data shows that banks in these countries will face around EUR 510bn in 5 Fixed Income Watch - TLTRO: bazooka or peashooter? - 10 September 2014 redemptions of senior unsecured bonds, covered bonds, and unsecured debt as well as covered bonds to narrow more government guaranteed bonds next year and in 2016. If we sharply in these countries than in the periphery. take this as a benchmark, this year’s TLTROs will cover around 20% of total bank debt redemptions in 2015 and 2016. However, there are also factors working in the opposite Graph 5 shows the breakdown by country, revealing that in our direction. First of all, supply in the core countries will decline, base case, almost 30% of redemptions of Dutch and French which forces investors to put their money to work somewhere banks (in 2015 and 2016) will be covered by TLTRO funding. else. The periphery is then an attractive destination, especially This is a significant amount, but still does not imply that issuers when taking into account investors’ search for yield, which we will stay away from capital market funding altogether. They will expect to intensify further on the back of the ECB actions. only need less of it. Ultimately, we think that the search for yield will dominate. This suggests that spreads of covered bonds as well as senior unsecured debt are likely to continue to tighten in both the Figure 4 - Funding needs peripheral banks (semi) core and even more so in the periphery, with EUR bn unpleasant surprises from the AQR being a main risk factor. 160 140 120 100 80 60 40 20 0 Will there be a direct impact on bank bonds? The decline in supply of bank bonds will lead to lower yields. We expect a significant drop of unsecured yield curves in particular, since these are the most expensive for a bank to fund and match the TLTRO duration, although from a historical point of view, senior funding is currently relatively cheap. BE IR PT Deficit between LTRO and TLTRO ES IT Bank debt redemptions 2015/16 Covered bond programmes are likely to be less affected (although we would still expect yields to go down, not least due to the ECB’s buying programme), because they are cheaper funding than unsecured bonds and their maturity is generally Source: Bloomberg, ABN AMRO Group Economics longer than that of the TLTRO. This means that the introduction of the TLTRO operations could ultimately lead to a Figure 5 - Surplus funding versus redemptions 2015/16 spread compression between 0-4yrs senior unsecured and covered bonds. % (share in redemptions) 35% On the flip side, in the event that supply will decrease and 30% especially the short end of the unsecured bond curve will 25% flatten, other investors who usually invest in these assets will 20% be crowded out. As a result, these investors should decide 15% between the next three alternatives in their search for yield; 10% move up the unsecured yield curve, move up the credit 5% spectrum to other assets, or buy medium maturing covered bonds, as they would have become relatively cheap compared 0% FR NL AT DE Source: Bloomberg, ABN AMRO Group Economics to unsecured bonds. Will the TLTROs lead to carry trades? If banks will primarily use the TLTRO liquidity to substitute external funding, this would decrease the likelihood and Will spreads tighten more in periphery of (semi)-core? potential size of structural and persistent carry trades. Overall, our analysis shows that the impact of the TLTROs on However, this does not mean that the carry trade will vanish, bank funding needs differs between the peripheral banks and as banks could have excess cash surpluses, at least those in the (semi) core. The former will most likely increase temporarily, and decide to invest in various securities, while wholesale market funding, while banks in the core are still adhering to the ECB’s TLTRO lending conditions. Tables 4 expected to reduce capital market funding. As such, supply in & 5 show the potential carry opportunity across government the (semi) core will decline versus that in the periphery in bond and SSA products (for covered and senior, see above) coming years, which would provide room for spreads of senior 6 Fixed Income Watch - TLTRO: bazooka or peashooter? - 10 September 2014 and the likelihood of carry trades for (soft) core banks and problems in terms of availability, liquidity and could increase peripheral banks. We assume that banks would choose to the riskiness of the carry trade. We therefore assume that invest their surpluses in asset classes which are close to their although the carry trade is more profitable in SSA and other own risk and or country profile. riskier products, the bulk of the potential excess cash would be invested in sovereign paper. If (soft) core banks would have a temporary cash surplus, all of their domestic government bonds and nearly all of the SSA Table 5 - Yields of SSAs (%) assets would not yield enough to provide a positive carry trade. Country Opportunities to set up a positive carry trade in SSA territory Maturity 1Y 2Y 3Y 4Y 0.06 0.17 are very limited and can only be found in the 4Y tenor (note Stability funds -0.02 -0.02 that the subclasses Stability funds, Multilateral funds, France Multilateral -0.03 -0.04 0.04 0.17 Germany 0.00 0.03 0.04 0.13 France 0.04 -0.06 0.09 and Netherlands are on the breakeven point, while only 4yrs Austrian SSA are yielding significantly more than 15bps). The large majority of these banks should move up the credit spectrum and search for yield in their domestic covered and senior unsecured markets, which yield more than the cost of the TLTRO. Italy 0.58 0.16 1.10 Spain 0.28 0.37 0.60 0.71 Netherlands 0.00 0.03 0.06 0.16 Austria 0.00 0.11 Another option for them would be to move up the maturity Belgium curve, but we think that this would be less likely, although this Portugal would be viable, as short end covered and senior unsecured Ireland paper would be increasingly hard to find. Another alternative Greece would be to set up a negative carry trade. The rationale behind Source: Bloomberg, ABN AMRO Group Economics 0.09 2.17 0.35 0.28 2.40 this is that banks would be willing to pay a premium to secure term funding, as the TLTRO is considerably cheaper than their Overall, since yields of short-term government paper are own sources of covered or unsecured funding. Banks could, already anchored and investors are constantly hunting for albeit to a minor extent, still be willing to invest their temporary yield, we expect that covered and senior unsecured bonds of excess cash positions in government or SSA bonds. core countries are the most likely candidates to be used by (soft) core banks for carry trades. This would re-enforce the Table 4 - Yields of government bonds (%) Country trend of lower yields described above, and see a 3-10yrs steepening. Peripheral banks will probably stick to their Maturity 1Y 2Y 3Y 4Y domestic sovereign bonds due to liquidity and additional risk Germany -0.08 -0.06 -0.04 0.00 factors. This would lead to lower yields (especially in the short France -0.04 -0.04 0.01 0.07 end), a further tightening of short end peripheral government Italy 0.23 0.41 0.63 0.78 paper vs core paper and 3-10s steepening on each individual Spain 0.26 0.26 0.41 0.68 Netherlands -0.05 -0.05 -0.02 0.07 Austria -0.06 -0.03 0.01 0.10 Belgium 0.04 -0.04 0.00 0.09 Portugal 0.31 0.53 1.01 1.35 Ireland 0.04 0.00 0.16 0.30 3.15 3.87 Greece Source: Bloomberg, ABN AMRO Group Economics Logically, peripheral banks have far more carry trade opportunities. First of all, they could decide to invest in their own sovereign paper (SP, IT, PO, IR, GR), as even 2yrs maturing bonds yield more than the TLTRO cost of funding. Another choice could be to invest their cash temporarily in SSA, covered or senior bonds, although this could pose peripheral government curve. What will the impact on bank lending be? Although the TLTROs on their own will not make the difference for the outlook for bank lending, they are part of a comprehensive package of measures by the ECB, which is starting to look formidable. The AQR and stress tests should increase the transparency of bank balance sheets and lead to stronger capitalisation where necessary. The ECB is also launching an ABS purchase programme, which will revive a key market for bank funding, as well as allowing banks to remove some assets from their balance sheets. In addition, demand for bank loans is starting to recover. All this suggests that eurozone bank lending should gradually recover over the coming quarters. 7 Fixed Income Watch - TLTRO: bazooka or peashooter? - 10 September 2014 DISCLAIMER ABN AMRO Bank Gustav Mahlerlaan 10 (visiting address) P.O. 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