What the Euro-Zone’s Long-Term Refinancing Operation (LTRO) Means for Canadian Mortgage Rates

Last Wednesday the European Central Bank (ECB) completed round two of its Long-Term Refinancing Operation (LTRO). This program is the single biggest reason that the euro zone has so far avoided a financial meltdown.

The LTRO has given euro-zone banks two chances to borrow as much money as they want from the ECB for a three-year fixed-rate term at a 1% interest rate, provided that these banks pledge balance sheet assets (such as sovereign bonds) to the ECB as collateral. The amount of collateral required depends on its quality, but the terms are generous.

The LTRO was designed to stave off a euro-zone financial crisis by providing several short-term benefits to the euro-zone’s seventeen member countries:

• It ensures that euro-zone banks have enough short-term capital (liquidity) to cover their maturing loans over the next three years (something which had been increasingly in doubt).
• It gives euro-zone banks the chance to make a substantial profit by borrowing at 1% and using the loan proceeds to buy sovereign debt at substantially higher rates (often referred to as a carry trade).
• By creating the conditions for this low-risk carry trade, the LTRO has fueled euro-zone bank demand for high-yielding sovereign debt. This is why Italian and Spanish bond yields are substantially lower of late. (Spanish and Italian two-year bond rates have fallen to less than 2.4%, compared to 3.6% and 5% before the program began, and both countries have seen their longer-term bond yields drop dramatically as well.)

By forestalling the most immediate threats to euro-zone banks, it was also hoped that LTRO would help get them lending again, particularly to small and medium-sized businesses which are so vital to the euro-zone’s long-term growth prospects. So far though, this outcome has not materialized.

In round one of the LTRO (initiated on December 21, 2011), 500 banks borrowed US $600 billion from the ECB, and round two saw 800 banks borrow and more than US $700 billion. The scope of eligible collateral for the program was also expanded in round two, bringing the financing arms of consumer-products companies (such as euro-area car makers) into the fold.

But while the LTRO has provided some much needed short-term liquidity relief, it hasn’t done anything to address the region’s fundamental problems of low growth, high unemployment and excessive debt. (One analyst recently estimated that European banks must cut their leverage by US $3 trillion over the next eighteen months.) And shorter-term benefits aside, what will be the long-term impacts of the ECB’s unprecedented and massive balance sheet expansion? The program is supposed to (in theory) expire in three years, but most analysts think that deadline was created only so that the ECB could avoid classifying the LTRO as quantitative easing (which is anathema to the German psyche).

Five-year Government of Canada (GoC) bond yields were basically flat for the week, closing one basis point higher on Friday at 1.42%. Five-year fixed-rate mortgages are widely available in a range from 3.19% to 3.39%, and as always, borrowers who shop around can do a little better.

Five-year variable rates are still within .5% of five-year fixed rates, and at those levels there just isn’t much reason to take floating-rate risk.

The bottom line: What does the ECB’s LTRO mean for Canadian mortgage rates? It virtually eliminates the immediate ‘tail risk’ of a euro-zone meltdown that could spur higher interest rates around the world, but it also keeps alive the potential for more of the bad euro-zone news that has been fueling demand for the relative safety of GoC bonds. In other words, the LTRO essentially preserves the conditions that have kept our bond yields, and by association, our mortgage rates, at ultra-low levels.

As if on cue, last Friday the euro zone’s finance ministers partially delayed Greece’s second bailout, requiring Athens to show more commitment to its recently agreed upon austerity measures .