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Since I recently submitted my MSc in Finance dissertation titled «The informational content of SMP deposit auctions in forecasting short-term repurchase agreement interest rates», I would like to take the opportunity to write a few words on its conclusions. The main objective of the research was to examine whether SMP deposit auctions carried valuable information for forecasting short-term repo rates. Since banks with excess liquidity always faced the choice between parking their reserves at the weekly term-deposits for a week or lending them in the GC repo market, SMP deposit rates should act as an effective floor on risk-free money market rates.

In order to evaluate the above hypothesis the paper first suggested a stochastic model for the bid rate in auctions (based mainly on the level of excess reserves in the system) as well as the conditional variance of the bid rate process (the calculation suggested that the variance was not steady but a function of excess reserves therefore implying that a possible econometric specification would face heteroskedasticity problems).

The econometric specification used a cointegrating relationship between the weekly GC and SMP deposits rate in a VEC model also containing excess bids, number of bids and the VIX index (as a proxy of market stress) as explanatory variables. A competing VAR model of the MRO and GC rate was estimated and out of sample forecasts of the GC rate for the two models were compared. The results clearly indicated that the SMP deposits did provide significant informational content for short-term money market rates.

A few people might find the (very) large section in monetary policy and repo market details informative and helpful. Overall the paper is quite technical but I hope relevant for evaluating the effectiveness of certain sterilization tools used by central banks in recent years. It might prove useful in analyzing related facilities used by the Federal Reserve (such as Interest on Reserves and the overnight and term reverse repo facilities), a topic that interests myself as well.

UIP obviously stands for Uncovered Interest Parity. The following is a crude visualization of its explanatory strength. The graph depicts the difference between real 12-month Libor rates for Euro and USD against the change in the US/Euro exchange rate. An increase in the real spread should lead to a Euro appreciation with the two graphs moving in the same direction (data are monthly since January 2007):

real 12m-libor USD euro - exchange rate movement

It is quite evident that the two series are highly correlated (correlation coefficient of 0.65 with R² equal to 0.42). What is very interesting is the fact that the spread is driven by inflation differentials between the Eurozone and the US (as a result of current disinflationary forces in the Euro area), since nominal rates have converged in the two regions:

libor-euro minus libor-usd

Obviously the above graphs are rather crude and a better indicator of future inflation rates would be inflation swap rates. These might help explain recent exchange rate movements (which are not easy to explain in the first graph).

In any case, the relative unwillingness of the ECB to act upon the disinflationary forces in the Eurozone does have its toll on the exchange rate which might negate a large part of the improvement of the RER. How far inflation rates will remain weak is going to play a crucial role on future exchange rate movements.

Taking a look at recent ECB term deposit rates (the 7-day term deposits used to sterilize SMP liquidity) one will observe that rates have expanded somewhat from 1bp to 4-5bp (the latest auction settled around 5bp):

ECB SMP Term Deposit Rate

Total amount of bids has also fallen below €300bn (with SMP liquidity around €206bn). This indicates that overall excess liquidity has fallen considerably (based on the term deposits auctions to lower than €100bn) and is pushing short-term rates higher. This is reflected on overnight repo rates with the Eurex GC Pooling EUR Funding Rate climbing to 4-5bp. LTRO repayments and lower Target2 balances have started having an impact on money market rates. The latest auction only had €254bn in bids and is a good indicator of available funds in the Euro money market.

Falling excess liquidity will start pushing money market rates closer to the cost of funds (currently 75bp). Unless the latter is lowered by the ECB it is possible that money market lenders will start avoiding long repo maturities and focus on short-term deals (overnight/weekly). It also points to a higher probability of an ECB rate cut in the immediate future.

Lately, there’s (finally) some talk about a Large Scale Asset Purchase (LSAP) program from the ECB. I ‘d like to elaborate a bit on the implementation of such a program since the Eurosystem structure and the segmented government debt market pose certain issues.

Usually, LSAPs are used mainly to steer long-term interest rates and provide monetary stimulus to the economy by making financing of durable goods purchases and long-term investment (like housing) more affordable. In the Euro case though, the main problem is the disfunctioning monetary transmission mechanism with certain government securities not being perfect substitutes with bank reserves. This is evident if one compares yields with corresponding Overnight Index Swaps:

Euro government securities - OIS

Since there’s still excess liquidity in the Euro banking system, EONIA mostly arbitrages with the ECB deposit rate rather than the MRO rate (since banks with excess liquidity are not the ones borrowing excess funds). As a result, short-term government paper should be mostly considered as the equivelant of a fixed-term deposit at the ECB, making them close substitutes with bank reserves.

It is clear from the above table that core countries securities actually carry a premium (compared to unsecured interbank lending swaps) up to 1 year and arbitrage quite closely for longer maturities. On the other hand, Italian and Spanish paper carry considerable risk and are ideal targets for LSAP. Any GDP-weighted LSAP would waste a large part of resources without having any real ecnomic impact (since they would be a perfect asset swap, replacing assets with roughly the same ‘economic value’).

An important issue with LSAPs is which NCB will actually perform the purchases. As long as non-issuer country NCBs buy securities, any coupon payments will register as an increase in Target2 liabilities (for the issuer country) and contribute to the Eurosystem profits (minus the fixed-term deposit rate used to sterilize any purchases). Unless monetary profits are remmited back to the issuer Treasury, they will be removing domestic interest income and not contribute to any reduction in the current account income deficit of the issuer.

Taking an accounting view, LSAP will remove an interest bearing asset from bank balance sheets and replace it with bank reserves which currently pay close to zero (zero for the deposit facility and close to zero for the fixed-term deposits). The most probable impact will be a reduction in net lending from the ECB by the banks selling the assets, although the speed will depend on if their loans are short-term (MROs) or long-term (LTROs). The net income impact would probably still be negative while it would allow for collateral to be removed from ECB borrowing and made available in private money markets. Any capital gains would provide immediate income for sellers and lower collateral needs of banks borrowing from the ECB and using government paper as collateral (due to positive effects from daily mark-to-market). As a result, a LSAP announcement would probably be followed by excess liquidity banks trying to front-load the ECB.

Since the ECB uses weekly-term deposits to sterilize the impacts of any asset purchases, the net effect would be a reduction in liquidity available for private money markets and a probable push of interbank rates closer to the MRO rate. This means that any LSAP would be accompanied by a reduction of the MRO rate to lower levels such as 0.5% in order to avoid a defacto monetary tighting stance.

Overall, LSAP can be positive but can have several unintended consequences.

The ECB released its Euro money market survey for 2012. The observations are quite interesting. Both the unsecured and secured money market daily turnover is lower in 2012.

The unsecured market structure has changed in 2012 with trades moving mainly at the national level while intra-euro lending dropped significantly:


while market participants do not regard the market as efficient and liquid:


The secured market structure on the other has held tight:


probably because trades are moving through central counterparties, thus limiting exposure for lenders:


Another factor is the fact that maturities are shorter, both in the overall market:


and the bilateral repos (which consist the largest part of the market):


When one takes a look at the total market structure it’s obvious that both the secured and unsecured market is dominated by the top 20 credit institutions:


As a result, developments such as the fall in intra-euro unsecured lending should not be considered marginal but significant, since most of the remaining trades are probably accounted for by these top-20 institutions and do not change much.

The ECB released the Euro area Investment Funds statistics for June 2012 which also include the Q2 data. Although they do not include the decision to drop the deposit facility rate to zero (which happened in July), the flow data are quite interesting.

In particular, investment funds increased their securities holdings by €58bn in 2012Q2 (30bn in transactions and €28bn in revaluations), a 2,2% increase mainly due to an increase in holdings of securities issued by non-euro area residents. Euro area securities holdings increased only by €4bn. Shares on the other hand dropped €72bn, mainly due to revaluations (-€60bn), a 3,8% drop. During 2012Q1, flows were +€170bn for securities (€69bn in transactions and €102bn in revaluations) and +€150bn in shares (almost exclusively due to revaluations).

Money market funds on the other hand decreased their securities holdings by €33bn (mainly because of outright transactions), a drop of 4,2%. In 2012Q1 the flow was a positive €17bn with €77bn in transactions (and a €60bn negative flow due to revaluations).

Both investment and money market funds increased their deposit and loan claims substantially (+€49bn and €39bn respectively) while money market funds had actually decreased their exposure during 2012Q1.

Funds suffer from large revaluation losses in shares and are quite reluctant to increase their euro area securities holdings, moving funds to short-term deposits and loans.

In recent days, the ECB has started to pay closer attention to the fact that the monetary transmission mechanism of its interest rate policy is quite broken in the case of the periphery, making its rate cuts ineffective. The problem stems from the fact that both its own financing operations as well as general interbank lending is done through the repo market (in the case of the interbank market there is also the unsecured market although that is shrinking, especially for periphery banks). As a result, volatility in collateral values (either that posted on ECB operations or in private repo loans) plays a major factor in the effective repo rate (after margin calls are covered). Moreover, high volatility collateral leads to higher haircuts (so that the lender is safe from a large price move in case he had to liquidate his collateral) while periphery counterparty risk (undercapitalized banks with large NPLs and risky assets) leads to higher general repo rates.

Another factor is the large Target2 liabilities which are financed by central bank lending and increase the effective ‘liabilities cost’ of banks.

In such a context, rates will not be transmitted efficiently in the case of banking systems with high volatility collateral. The obvious solution is to lower volatility which can happen in two ways:

  1. Use credit claims as collateral which do not face daily mark-to-market although they are subject to large initial haircuts (making the effective loan capacity lower). The LTROs used such a framework by relaxing collateral rules on eligible credit claims (and also accepting government guaranteed bank private bonds).
  2. Lower the volatility of securities used as collateral which requires a buyer of last resort (a role that was played by the SMP portfolio and might be taken over by the EFSF/ESM).

Based on the above one can reasonably assume that further rate cuts by the ECB are not in the agenda until the transmission mechanism is fixed. That would necessarily involve some combination of relaxed collateral rules and a secondary market securities purchase mechanism (SMP or EFSF/ESM). The open question is if such a move would be enough to lower counterparty risk and increase private repo turnover/lower euro outflows from the periphery or if it will lead to the ECB being an even larger market maker.

For now interest rates on new loans (up to €1mn) to non financial corporations with maturity higher than 5 years are quite different in the periphery compared to Germany, although they should include significant local macro risk in the case of the periphery:

BdE published its monthly bulletin for July. Although all of the tables are quite interesting, i will focus on the GDP and money market statistics.

The economic deterioration is quite clear. Fixed investment shows an accelerating decline while final consumption has now turned negative, although not at levels seen in 2009. Government consumption is declining strongly, making a significant negative contribution to growth, something which is certain to become stronger after the July austerity measures and the bailouts of regional governments (which require further cuts in regional budgets). Exports have been the main source of demand for the Spanish economy but even they show a clear pattern of decline (with growth in the Euro area turning negative), lowering the prospects for the general economy.

More detailed data show that the decline in investment is not confined to construction anymore but includes other sectors as well. The decline in exports growth can mainly be accounted by goods, although services are also showing signs of trouble.

BdE projections for Q2 are negative:

«On preliminary estimates, based on still-incomplete information, economic activity in Spain fell again in Q2. The pace of decline was estimated to be sharper than that of the two previous quarters, with a quarter-on-quarter rate of change of -0.4%. National demand fell off more markedly than in the previous quarter (-1.2% against -0.5%), since household spending and general government demand shrank at a quicker pace. As has been the case in recent years, net external demand softened the adverse impact of the decline in national demand on GDP, as it made a positive contribution of 0.8 pp, up on that of the previous quarter, thanks to a moderate pick-up in exports. In year-on-year terms GDP declined by 1%, set against -0.4% in Q1.»


The money market data show that conditions in Spain have worsened in May and June. Unsecured financing seems to only be available for terms up to one month while secured financing up to 3 months. Unsecured loans interest rates increased from 0.48% to 0.83% while repo rates from 0.20% to 0.32% for 1 month, 0.21% to 0.77% for 2 months and 0.45% to 0.93% for 3 months. It is clear that counterparty risk has increased heavily and lenders are anticipating troubles in the summer.

Since Friday, Spanish bond yields are clearly over the 7% threshold making market access and debt sustainability a challenge. I ‘ll take the opportunity to look into more details on the Spanish balance sheet regarding other residents.

The first table includes main liabilities to RoW based on BdE balance of payments data which are only available till 2012Q1 (they will be updated on 31 July):

What is clear is that the main driver of capital flight is a drop in securities investments. Money market instruments also show a large drop, mainly in the general government sector, although the relevant positions were already quite small. In my view this is a clear case of an asset class not being considered ‘safe’ anymore (in the Gary Gorton terminology) with investors moving out of it. Both the Spanish government and economy are now viewed as a higher credit risk instrument, with funding dropping both in the bond (Held to Maturity) and money market areas.

The same is evident if one looks at monthly flows of direct investment (with portfolio investment being the one mainly hurt):

Things are much clearer by looking at more specific data from the BdE (balance sheet data for the BdE and credit institutions), as well as the Spanish Treasury:

The first observation is the significant drop in RoW deposits in credit institutions, deposits which should mainly be considered as part of money market funding. The drop in securities liabilities is much lower than the one observed in the balance of payments data, suggesting that resident banks found new domestic sources of funding (most probably with the help of BdE).

On the government debt front, Treasury data show a large drop in RoW (permanent) holdings, which is covered by an increase in holdings by domestic credit institutions. By subtracting the Net position from the outright holdings, one can calculate the outstanding repo funding from the RoW. Repo funding reached a high in September 2011 but has dropped significantly ever since, especially during 2012. This is another indication of elevated counterparty/collateral risk which leads to a large ‘haircut’ in funding.

Adding up the drop in outright holdings and repo transactions, a large part of the external position (and target2 liabilities increase) deterioration can be explained by foreign investors moving away from the Spanish bond and repo market. The repo/money market drawback is evident in the balance of payments other investment data as well:

Clearly a warning sign is the large decrease in turnover in the outright transactions (bond) and repo markets since February. This was the main pattern observed in the Greek case, with outright trading coming to a halt and price discovery moving to the CDS market with bond yields following CDS spreads (instead of the opposite) since the derivatives market became the most liquid. One thing to keep an eye for is the CDS net notional. If that starts dropping with opposite movement in the gross notional that will mean that market participants are not creating any new net contracts (which ultimately require a short position on the underlying instrument) but only leverage existing contracts by shorting CDS while covering the position with an older long position. This would indicate an unwillingness to take the original credit risk and a difficulty in covering a short position in the bond market. The intermediation trade is probably a nice arbitrage trade since collateral will be provided by the original seller or the new buyer of the contract (depending on how CDS spreads move).

This chart for the Spanish CDS net notional (from ftalphaville) is not good. Current gross/net notional is $171.6/13.7bn while they were $163.2/13.9bn a month ago.

A positive number is the total government deposits available which stand at a little over €90bn. Given the current government debt redemptions schedule and net funding needs, the government does have some leverage in the short-term until probably October (when redemptions are €27.4bn), even if it cancelled all new auctions (except for T-Bills) since most of the redemptions actually concern t-bills (which i think can be covered by domestic credit institutions in any case). With that in mind, i don’t see an immediate reason for a full bailout, at least not until the ESM is allowed to be activated by the German constitutional court in September (since financing through the EFSF for sovereign needs would mean removing the Spanish guarantees). One can probably safely acquire (outright or as collateral in a repo transaction) any debt maturing until October.

I ‘ve already stated my views on the ECB zeroing the deposit facility rate which i think will lower money market turnover and push most returns on repos and high quality paper negative (something which is already happening). One of the areas where negative rates are destined to bite hard is pension and investment funds. They are risk averse investors and mostly invest in high quality securities (held to maturity) and repos. Zero and negative returns are certain to make their life much more difficult and in the long run make covering their future liabilities (pensions for an ever aging population) a challenge.

Based on the most recent ECB data (pension funds, investment funds), pension funds hold €797bn in deposits, €468bn in loans, €1232bn in general government securities (and 2812bn in securities in general) and €1701bn in investment fund shares. Investment funds have a total of €6056bn in assets, with €2107bn in bond funds and €1496bn in mixed funds.

Probably more than €5tr in assets are in the risk of earning much lower (or negative) returns (especially in the case of investments in AAA assets). Just a 25bp drop in interest rate income translates in more than €12bn less income annually which will ultimately mean less direct income for households (through returns on their fund shares or in their pension income) or more borrowing from governments in order to be able to pay for pensions.

Dropping interest rates to zero or even negative territory should be regarded as it really is, an indirect tax on the economy with deflationary dynamics since it ultimately just destroys money.

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Kostas Kalevras

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