Were you puzzled by the immediate reaction of the euro following Wednesday’s LTRO?

Icap’s Don Smith, has a rather compelling interpretation.

And it’s all to do with currency basis swaps and the ECB’s dollar funding operation:

As Smith explains :

It might appear odd to some, that in the wake of yesterday’s massive US $33bn allocation at the ECB’s extended 14-day US$ tender to cover the holiday period , eur/usd basis has moved lower, signalling at face value that this massive US$ tender has had little effect in satiating US$ demand from Eurozone banks, so what’s going on?

By way of background, the short-end eur/usd cross currency basis curve has become something of a barometer of demand for US$ and indirectly global risk aversion . The more negative this basis the greater the relative demand for US$ versus € and it has moved to some extremely negative levels of late. Naturally the recent occasions when the US$ funds have been made more available to eurozone banks have caused the basis to move less negative as US$ demand has been partly satiated. The co-ordinated central bank announcement on 30th November which lowered the rate offered on US$ tenders from US$ OIS +1% to US$ OIS + 50bp, triggered a massive jump in 3-month eur/usd basis from -163bp to -130bp and news of the jump in US$ allocation at the ECB’s weekly 7-day US$ tender on Wed 15th Dec triggered a move from -152 up to -127bp. So why hasn’t yesterday’s much larger than expected US$ allocation moved the basis higher again?

The key reason relates to the relative nature of these basis markets. The eur/usd basis represents a barometer of demand for US$ relative to euros. And big as it was, yesterday’s US$ tender occurred at the same time as the ECB has completed flooded the Eurozone money market with euro cash through its 1-week, 3-month, but especially its 30year euro tenders. We think that around €210bn of this was new funding, the remainder being sourced from the maturing 3-month LTRO , the 7-day OMO and October’s 1-year LTRO .

The effect of this deluge of euro cash has been to all-but obliterate strength on the bid-side of the eur/usd basis market . As a result, reduced demand to receive US$ through the basis in the aftermath of yesterday’s US$ supply, which would typically drive the basis higher and offer a signal that US$ demand has been partly satiated has had little effect because on the other side of this trade, demand to receive euros gas dropped even further due to the ECB’s euro liquidity splurge.

In short, so much euro liquidity hit the market that it didn’t matter that the ECB had just had a successful dollar funding operation. No one was willing to price currency basis swaps in any other way but one which reflected a dollar drought situation during a euro flood.

In such a situation, the euro has no choice but to fall.

Similar Posts:

Share