Deutsche Bank - "Each week - beginning with an announcement this Friday - Euro-area banks will have the option to re-pay part of the more than 1 trillion in 3-year LTRO liquidity drawn a year ago from the ECB. Many observers play down the FX impact of these prepayments as insignificant. In contrast, we think it is a major milestone.
First, the ECB will now stand out as the first central bank in the world where exit from unconventional policy is beginning. For all the focus on the timing of Fed exit, the ECB balance sheet is about to shrink in a manner equivalent to the Fed selling Treasuries. Eurosystem excess liquidity has already dropped by close to 200bn EUR on the back of lower MRO take-ups. But the opening of the prepayment window will accelerate this process. Indeed, even assuming a 5bn weekly run rate on the prepayments - equivalent to an unwind of only half of the vLTROs - would result in an end-14 excess cash position close to that prevailing before the 2008 crisis.
Second, and as a consequence of the above, a shrinking ECB balance sheet has the potential to lead to "stealth" rate hikes even before the Fed ends QE. Because the EONIA money market demand curve is convex, an initial 100-200bn prepayment (as the market expects) will have a modest impact on the short-end of the curve. Our fixed income team note that excess cash needs to drop below 300bn for a bigger effect. LTRO prepayments run on a weekly basis, however, and the market is forward looking in its behaviour. Irrespective of the initial amounts announced this Friday, "liquidity wind-down" risk will be a latent force creating greater two-way moves in Eurozone yields and will contrast strongly with the Fed's commitment to keep policy rates fixed through 2015.
What is the implication of all of this for EUR/USD? Ultimately, and as the 2008 and 2010 experiences showed, premature tightening may force the ECB to backtrack and may even make the Eurozone crisis worse later in the year. For now, however, we view tighter policy as highly supportive of the EUR. At a time when Fed balance sheet expansion is running at full throttle and all ZIRP currencies are competing for funding status, the "Great Exit" is beginning on the European side of the Atlantic. Combined with our view of upside risks to Euroarea data on the back of a positive credit impulse in coming months, we view the LTRO prepayments as a significant positive for the euro. We continue to target a break above 1.35 in EUR/USD and remain bullish vs GBP,CHF and JPY as well."