Just as the US markets have their “Don’t fight the Fed” adage, it will not pay to fight the ECB during 2012 now that it has brought out its “Superwaffe” and started to conduct regular 3-year Long-Term Refinancing Operations (LTROs).

Buoyed by the success of the first 3-year LTRO (conducted in December 2011) and the effect it seems to be having in lowering the sovereign debt yield curves across the eurozone (with the correct exception of Germany), Draghi commented at yesterday’s ECB press conference that the second 3-year LTRO (due at the end of Feb 2012) was expected to result in a substantial allotment too (the first allotted €489 bln to 523 banks), in particular because the procedures will be in place by then to allow eurozone banks to use their loan books as collateral.

Let’s play “follow the money” – always an instructive game.  Whilst the Dec 2011 LTRO saw a net €213 bln borrowed from the ECB (after netting off borrowings rolled over from prior LTROs) and a similar amount of €198 bln left on deposit at the ECB, Draghi was keen to point out that the banks depositing the money were not the same as the banks borrowing money in the 3-year LTRO.  He also explained that the amounts borrowed by individual banks corresponded very closely to the amount of debt they had maturing in Q1 2012.  What this means is that the obstacle of €240 bln of eurozone bank debt maturing in Q1 2012 has been removed in one fell swoop.  Banks will not be forced to issue new debt (at steep yields) to refinance the old maturing debt and they now have a 3-year window to manage their liquidity.  Investors who own this soon-to-mature bank debt now have to find a place to re-invest €240 bln – they could either lend it to the EFSF (which recently borrowed 91-day money at 0.22%), lend it to Germany (which borrowed six-month money for a negative yield this week) or lend it to other eurozone governments (Italy borrowed 136-day money at 1.64% yesterday).  It is clear that investors are compressing eurozone yield spreads (against Germany) and also clear that this trade has further to run.  There is currently €463 bln parked on overnight deposit at the ECB by banks (earning 0.25%) and it will pay to keep a close eye on where this money goes to.  Anyone fancy buying 10-year Spanish bonds at 5.13% ???

The Bank of England recently highlighted that eurozone banks have €600 bln of debt maturing during the whole of 2012.  It is quite feasible that eurozone banks could borrow the whole €600 bln from the ECB via 3-year LTROs which would leave bond investors with €600 bln to re-invest – and they will soon be competing with the EFSF to buy eurozone sovereign debt.  One can but admire the ECB as it seems to have engineered a sustainable fall in stressed eurozone bond yields without actually having to buy unlimited quantities of eurozone sovereign debt itself (whilst at the same time sorting out the overhang of banks’ 2012 debt maturities).

Note also that Draghi used the word “second” rather than “final” to describe February’s 3-year LTRO.  Central bankers are extremely careful in their choice of words and we can expect more 3-year LTROs to be conducted by the ECB, especially since this particular weapon is proving to be particularly effective in calming the sovereign debt markets and is buying the eurozone governments time to get their budget deficits down and then to pass legislation to ensure that they do not balloon out of control again in the future.  The ECB is not afraid to deploy this weapon in real size and market participants would be foolish to fight the ECB.  The stage is set for eurozone sovereign bond yields to continue to converge with Germany (Greece excepted) and for equities to continue to rally (except for those banks launching rights issues).