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Will LTRO Spoil The Risk Rally?
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Will LTRO Spoil The Risk Rally?

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Will LTRO Spoil The Risk Rally?

For the past two months, troubled European bond markets -- and the rest of the risk asset world -- have been riding the coattail of the European Central Bank's long term refinancing operation in December. Next week will bring the second, and at least for now, last, 3-year LTRO, as its better known. An important question for the markets is will this LTRO live up to the hype?

In the eyes of many investors the LTRO took off the table the systemic risk of a Lehman-esque collapse of the European banking system. Plus, banks in some countries (we're looking at you, Italy and Spain) appear to have used the oodles of cheap cash from the ECB to buy short-term debt issued by their home countries.

The December LTRO doled out EUR489 billion euros in cheap loans. Expectations for next week's LTRO, when countries submit their bids on Wednesday with the moola awarded Thursday, are all over the map. Some analysts expect the loans to total roughly the same amount but forecasts range upwards of EUR1 trillion euros. ECB chieftain Mario Draghi has said he expects this LTRO to come in at roughly the same size as December, but it's impossible to know if he's trying to manage expectations down to get a bigger bang for their buck (or rather, euro).

Mark Nash, a London-based bond fund manager for Invesco, says that while the LTRO was important in reducing fears of systemic risk, he also thinks any additional positive impact from the next LTRO will quickly fade.

"I expect we'll start to see some soggy auctions and the markets will again be disappointed," he says. Nash says he's been adding to short positions in French and Spanish government debt and tilting toward German, U.S. and U.K. government debt.

For starters, he questions the appetite among banks for continuing to load up on sovereign debt, where the economic and fiscal fundamentals remain shaky. "If you're a European bank shareholder, I don't think you would be too impressed with your bank continuing to be buyer of last resort" of sovereign debt. At the same time, the ECB has made its distaste for buying sovereign debt very clear.

Private investors, meanwhile, will remain wary of peripheral debt, he predicts. "Government bond holders are a group that want their money back," he says. But a recessionary economic environment will mean the prospect for default by countries other than Greece will continue to loom over the market.

More broadly, Nash thinks the European bond market, along with stocks and other riskier investments, has gotten a boost from better economic data in the U.S. and elsewhere around the globe. However, he thinks the markets are now too optimistic about the pace of global growth.

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