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The ECB may announce more details of what it has called "modalities" or rules of engagement for the TLTROs.  Some small banks, which do not have access to the ECB's facilities, could participate in the TLTRO through a larger bank, for example.  Although the ECB has indicated this, few have focused on the implication.    Since the cost of TLTRO funds is 10 bp above the repo rate, a repo rate cut on the eve of the TLTRO may also help encourage stronger participation. 

The purpose of the TLTRO funds are to facilitate lending to the private sector and not buying sovereign bonds (carry trade), there are not penalties for using the funds for precisely that.  Our understanding is that if a bank's net lending is below the benchmark as of April 2016, the bank will simply have to repay the TLTRO funds in September 2016 instead of September 2018. 

That is to say; banks will get to have two-years of low cost funding regardless of the evolution of their loan portfolio.  On the assumption that banks will be reluctant to take on fresh maturity mismatches, we suspect that the prospect for a repo rate tomorrow and TLTRO borrowings has been a key factor behind the rally short-end of the euro area coupon curves.  The two-year yield in Germany and the Netherlands are negative.  France also flirted with negative territory in recent days.

Given the rally rally in European bonds, the carry trade is not as attractive as it may have been previously.  However, the cost of the funds is still cheap and, if we are right about a repo rate cut, practically for free (5 bp annualized).  This is, of course, cheaper than any other funds that banks can source.  This is doubly true for smaller and weaker banks.

What about a full fledged QE program from the ECB?  With the OMT issue still before the European Court of Justice, we do not think there is a critical mass necessary to support the effort.  Moreover, given the euro's decline, about 3% against the dollar since the negative deposit rate was introduced, and a little more than trade weighted basis over the past six months, which is tantamount to some easing of monetary conditions, we suspect there is a reasonably good chance that inflation bottoms in the September-October period.   This may be reflected in the new staff forecasts that will be published tomorrow (and won't be updated until December.

On the other hand, if inflation does continue to fall and deflation looms, we can envision a scenario for QE.  In order to win the acceptance by Germany and other creditor members, a European-style deal would have to be arranged.  Consider that Italy's President Napolitano wants to step down.  He was persuaded to stay in office longer than he intended.  He turns 90 in the middle of next year, and reports make it clear that he would like to retire before then.

Draghi may get German support for QE if Germany could oversee its implementation.  And recall that with Lithuania joining EMU, a new voting regime at the ECB will be instituted in January 2015.  Not only are the number of policy meetings reduced, but also, not all members, including Germany will vote at each meeting.  This is ruffling more than a few feathers in Germany. 

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