PARIS (MNI) – Some kind of ECB operation to smooth markets when
last June’s E442 billion one-year LTRO expires at the end of this month
is possible but not definite, well-placed monetary sources told Market
News International.

The amount of liquidity pulled from the system when those LTRO
funds are paid back amounts to more than half of total outstanding ECB
loans to credit institutions — and over 90% of net outstanding loans
once funds on deposit at the ECB are subtracted.

That will be the “real test” for money markets, said one official.
“It’s a big question. It’s being debated. We are aware the market wants
to know,” he said. The question is do you “re-create” that liquidity.

One source suggested there could be some kind of limited rollover
to smooth the transition — a month, for example.

On the other hand, there are plenty of fixed-rate, full-allotment
operations already on the schedule, including the weekly main
refinancing operations and one-month operations, which the ECB has
pledged to continue conducting at least until October 12.

In addition, the ECB announced on May 10 it would conduct a new
six-month auction, as well as two three-month operations, on a fixed
allotment basis. The six-month and one of the three-month tenders have
already taken place. The second three-month operation is scheduled for
June 30, coinciding with the expiry of the one-year LTRO.

It could be that with all those full-allotment operations already
in the pipeline there will be enough to avoid big hiccups when the
one-year LTRO expires.

But even if the ECB does opt for an additional smoothing operation,
sources say it won’t be another one-year LTRO.

Conditions after the LTRO expires will thus be moving in a tighter
direction, though as the sources noted, there is still plenty of
liquidity sloshing around the system and many banks, unwilling to lend,
are simply parking it in the ECB’s overnight deposit facility, which
swelled to over E300 billion last week.

Although the ECB is still clearly in emergency liquidity-providing
mode, it is determined to sterilize the proceeds of its government bond
purchase program.

But one of the sources argued that with plenty of unsterilized
liquidity already being provided by the ECB’s balance sheet, not too
much should be read into the sterilization of the bond purchases. It’s
mostly window dressing — meant to avoid giving a “whiff of
monetization” — this official said.

Another official noted that so far the bond purchases have been
“modest,” and “the indications that have been published do not suggest a
massive operation.”

Sterilization was also politically necessary given the strong
hostility of Germany to buying bonds at all. One of the officials noted
that Germany’s Axel Weber was under enormous domestic political pressure
to vote against the decision, which he did. The Bundesbank president was
also thinking about his position as the front-runner to succeed Trichet
and wanted to project himself as the tough defender of ECB rigor, this
official opined.

All of the sources noted the bond purchase program was temporary
and would be ended as soon as the sovereign debt market could function
normally on its own. But they declined to say when that would be.

“The ECB will act as long as it needs to,” one of the officials
said. “It won’t be unlimited. It won’t remain eternally, but no one’s
fixing a date.” He added that the end of the program “will be signalled
when you see buyers and sellers for this paper lining up as normal in
the market.”

One of the other officials conceded that the ECB was worried about
a potential loss of credibility from its about-face on bond buying
within the space of days. But he and others argued that the bank had
little alternative. The reports from the market on the Friday before the
decision were “scary,” and the ECB had strong evidence that the bonds of
Spain and some other high-rated EMU sovereigns were being refused in the
repo market.

“Purchasing bonds is one of the emergency tools we used under
extreme circumstances,” said the senior Eurosystem source. “Since the
beginning of the crisis the ECB has said it was ready to use all means
necessary to safeguard the euro. And it did.”

Although buying up the debt of troubled peripheral Eurozone states
puts the ECB’s balance sheet at risk, the imperative of stabilizing
markets trumps any potential loss, the sources said.

“If you look at the past, national central banks have previously
posted temporary heavy losses as a result of doing what has been
needed,” one of the officials said. “It’s our task and it will have a
cost, but the issue is you avoid even bigger problems — and even bigger
losses — from occurring.”

Even beyond the ECB’s bond buying U-turn, officials expressed
concern at a chasm that seems to have opened up between markets and
officialdom. In part, it’s because markets and policymakers operate at
two very different paces, leaving financial agents edgy and impatient
for results, they said. Another problem, as in the case of Germany, is
that the demands of markets are often a hard political sell at home — a
reality that has led to some awkward communication.

One of the officials said there had clearly been “irrationality” in
markets as well. “For Italy and Spain, the markets are exaggerating the
situation,” he said. “If you look at the spreads before the crisis and
compare that to the degree that the fiscal situation has changed, the
[market reaction] is excessive.”

The senior source expressed optimism that confidence would return
to the markets, though it would take some time. He noted that because
the EU/IMF rescue plan for troubled Eurozone members took longer than it
should have, it “created a timeframe during which the markets had time
to speculate.” However, “the plan is now there for the markets to digest
and stability will gradually return — since I don’t believe other
countries besides Greece will need to use the mechanism.”

But the other official wasn’t so sanguine. He said we’ve entered a
“whole new era” in which many Eurozone political leaders “have lost the
habit of talking to the markets and speaking their language when
situations are extreme.” They used to have that discipline before the
advent of the euro, when there were big swings in national currencies
and interest rates. “Now they don’t have that.”

In addition, he noted, the decision-making process in the euro area
is slow by its very nature. “Balance that against how fast the market
moves and sends signals, and there’s an issue,” he said.

“The problem is not the way that banks are funded or their
resilience, it’s become the whole way the market works,” this source
said. The big question is how long we’ll be in this situation and
whether the measures taken by governments and by the ECB “can buy enough
time.”

–Paris Newsroom, +331 4271 5540; paris@marketnews.com

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