24/7 Wall St.

The European Central Bank (ECB) will offer the next round of its long-term refinancing operation (LTRO) on February 29th, and observers expect the EU’s banks to swap €470 billion ($629 billion) in short-term funds for three-year funds at an interest rate of 1%. The first such swap, in December, brought a total cash infusion to EU banks of €489 billion. There are no other LTRO deals planned.

Following December’s operation, banks parked a significant portion of the cash in sovereign bonds, taking advantage of the carry trade particularly in Spanish and Italian bonds. Currently, though, the spread has narrowed to about 262 basis points on Spanish debt and 287 basis points on Italian debt, according to a report at Bloomberg News. The spread between German debt and Spanish and Italian bonds has also narrowed.

This has led an analyst at Morgan Stanley to reach the following conclusion:

In the run-up to next week’s LTRO, we therefore continue to prefer covered bonds with a remaining term-to-maturity (TTM) of between three and six years, which still offer a discount of up to 100bp versus the short end of the Spanish market. We think this segment is likely to tighten versus swaps as investor demand increasingly moves out the curve in response to the short end becoming illiquid. The rationale behind this recommendation is that with shorter-dated paper having rallied markedly since the announcement of the first LTRO, the appeal for carry trades has considerably declined.

What, then will the EU banks do with the cash? The intention, of course, is that they will lend it out to businesses and consumers, giving the Eurozone economy a push. We’ll find out in a few weeks.