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Euro Posts Modest Gains Ahead of ECB's LTRO on Wednesday

Euro Posts Modest Gains Ahead of ECB's LTRO on Wednesday

Christopher Vecchio, CFA, Senior Strategist

Fundamental Headlines

- Durable Goods Orders in U.S. Slump 4%, Most in Three Years – Bloomberg

- German Court Raises Hurdle to Euro-zone Bailouts – Reuters

- Gold Firms with Euro, Stocks Ahead of ECB Financing – Reuters

- Focus Turns Now to Greek CDS Payouts – WSJ

- S&P Declares Greece in Default – WSJ

European Session Summary

With the first notification of a Greek default in the rearview mirror, market participants have already started looking ahead to the next major milestone in the European sovereign debt saga: Wednesday’s long-term refinancing operation by the European Central Bank. Despite the operation being ultimately dilutive to the Euro in nature (adding more Euros to the system diminishes their value), the Euro staged a small rally on Tuesday ahead of trading in New York.

This is the ECB’s second such liquidity operation in the past three months, with the first one in December showing a €498 billion take-up by European banks. The impact of all this extra liquidity sloshing around in the system is undeniably bullish: the FX Carry Trade index is up 5.27 percent this year. Now that all this extra cash is floating around in the global financial system, the outcome of the second LTRO is likely to be different. Early estimates expect somewhere in the range of €300 to €600 billion of additional take-up by European banks. The amount borrowed from the ECB is key for one simple reason: market sentiment.

On one hand, if the loan total is at the smaller end of the range, it is likely EURUSD bullish in the short-term but overall bearish risk-sentiment in the long-run. On the flipside, if the loan total is at the larger end of the range, it is likely EURUSD bearish in the short-term but risk-sentiment bullish in the long-run. The logic is simple: if banks need less liquidity now, the Euro won’t be diluted as much as it possibly could have been, and it will suggest that banks feel they are sound enough to withstand any shocks from the sovereign debt crisis.

On the other hand, if the total amount borrowed from the ECB is more than expected and at the larger end of the range, the Euro will be weighed down by the dilutive effect of the extra funds. However, as we’ve already seen this year, having extra liquidity in the system is bullish, as it would provide extra ‘insulation’ to banks when the sovereign debt crisis rears its ugly ahead in the coming months. The takeaway here is that the LTRO is a proxy to market confidence: the larger the LTRO take-up, the less confident European banks are.

EURUSD 5-min Chart: February 27, 2012

Euro_Posts_Modest_Gains_Ahead_of_ECBs_LTRO_on_Wednesday_body_Picture_10.png, Euro Posts Modest Gains Ahead of ECB's LTRO on Wednesday

Charts Created using Marketscope – Prepared by Christopher Vecchio

Overall, there was still little clear direction in terms of “risk-on” and “risk-off” in the Asian and European sessions, with the Australian and New Zealand Dollars leading the declines ahead of U.S. cash equity open on Tuesday. In terms of the top performers, the Euro and the Swiss Franc were outperforming their peers, gaining 0.31 percent and 0.29 percent against the U.S. Dollar, respectively. Meanwhile, the Yen continues to rebound against the U.S. Dollar, though as long as the USDJPY holds above 78.174 – the 61.8 Fibonacci retracement on the February move higher – the trend remains to the upside.

24-Hour Price Action

Euro_Posts_Modest_Gains_Ahead_of_ECBs_LTRO_on_Wednesday_body_Picture_7.png, Euro Posts Modest Gains Ahead of ECB's LTRO on WednesdayEuro_Posts_Modest_Gains_Ahead_of_ECBs_LTRO_on_Wednesday_body_Picture_1.png, Euro Posts Modest Gains Ahead of ECB's LTRO on Wednesday

Key Levels: 13:50 GMT

Euro_Posts_Modest_Gains_Ahead_of_ECBs_LTRO_on_Wednesday_body_Picture_4.png, Euro Posts Modest Gains Ahead of ECB's LTRO on Wednesday

Thus far, on Tuesday, the Dow Jones FXCM Dollar Index (Ticker: USDOLLAR) is trading lower, at 9790.17 at the time this report was written, after opening at 9808.97. The index has traded only lower, with the high at 9808.97 and the low at 9779.71.

--- Written by Christopher Vecchio, Currency Analyst

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com

Follow him on Twitter at @CVecchioFX

To be added to Christopher’s e-mail distribution list, send an e-mail with subject line "Distribution List" to cvecchio@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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