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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.

Today, the ECB decided to lower the MRO, marginal lending facility and deposit facility rates by 25bp to 0.75%, 1.50% and zero.

When trying to evaluate the possible results of today’s decision, one should bear in mind that the European banking system (and money market) is segmented. One part consists of core banks (German, Dutch) with large amounts of excess liquidity in the deposit facility while the other includes periphery banks with low levels of liquidity which sometimes have to use special refinancing facilities such as the ELA in order to cover settlement of (mainly inter-European) transactions. The flow of funds is not uni-directional but only flows from the periphery (bond maturities, deposit outflows, capital flight) to the core.

As a result, in general the periphery bears the cost of borrowing funds (at the ECB MRO rate since it does not really have access to the money markets), while the core uses the deposit facility to earn a risk-free return and/or invests funds in low-risk collateralized repo transactions. With that in mind, today’s MRO rate cut can only be positive since it will lower the cost of funds for (troubled) periphery banks, either through regular refinancing operations or ELA.

On the other hand, the elimination of the deposit rate marks the loss of strict control over the money market rates by the ECB (which started with the introduction of  the 3Y-LTROs). Ever since the 3Y-LTROs, excess liquidity pushed repo rates to extremely low levels of a few bp. Now, rates are only limited by the zero bound. Moreover, arbitrage opportunities between the deposit facility and the repo are now over, lowering the incentive for market making by large banks which helped the non bank money market participants (who did not have access to the deposit facility). Banks could bid for funds and deposit them at the ECB earning a spread and increasing the money market turnover, price discovery and maintaining low bid-offer spreads.

Now, the only risk-free return offered by the ECB is the weekly SMP term deposits, which will surely see new lows in rates and large offered amounts. Compared to a deposit facility of €800bn, term deposits of €210bn are rather small and auctions will become ‘crowded’.

Current (5/7) annual eurepo rates are 0.07% (offer rates are reported). In other words, a repo of 1 million Euros will only provide a return of 700€. Assuming a bid-offer spread of just 1bp, the return of market making will be only 100€ (on €1mn) and probably not even cover transaction costs, especially since most trades are for very short tenors. A market participant facing such low returns for large trades will only be rational to demand collateral of the highest quality possible. These numbers point to a strong decrease in market turnover with the European market ‘turning Japanese’. Given the high risks involved in the European money market, the most possible scenario is that participants will opt for principal conservation and only look for very low risk assets, pushing their yields even to negative territory (something that has happened with short-term German paper).

Financial institutions other than banks are almost as large as the banking sector in the Euro area:

These investors had the alternative of investing in the (secured/unsecured) interbank market for short tenors. A pension fund (and other investors) could loan available funds in the repo market for one month (in return for high quality securities), rollover the loan for 3 months (to the same or other counterparty) and earn an annualized rate of over 0.12%, which was much higher than rates on German 3-month T-Bills:

Now such trades are not available. Coupled with the fact that new securitisation issuance in the Euro area is limited (the 3Y-LTROs were mainly provided in order to allow previous securities to mature since new issuance was not possible), as well as the supply of safe assets, most short-term safe assets will see their yield turning negative very quickly.

Also, given the fact that the Fed pays 0.25% on USD bank reserves, banks with access to both deposit facilities should prefer USD in terms of risk-free returns.

The ECB probably expects more risk taking from its move today. In my view the result will be a decline of trading in the interbank market, negative yields and lack of profitable low risk trades. Providing the banking system with zero low risk returns is not a recipe for risk taking but rather for making the market smaller and less efficient.

In a sense, cash and bank reserves (at least those kept in the deposit facility) now have the same zero rate of return. They only differ in transaction and storage costs. I don’t see how making banks indifferent between holding cash or bank reserves (with the first basically only capable of settling small transactions with the public) is a monetary easing action.

Update 6/7: And here’s today’s eurepo rate curve. Rates for tenors longer than 2 months are under 2bp (although that is a product of averaging, actual rates are quoted in two decimal places). So the bid-offer spreads should be around 1bp with returns of 100€ for a €1mn trade. A number of participants are now actually quoting negative rates.

Eonia swap rates have also dropped significantly, while euro money market mutual funds have started denying new cash and short-term German T-Bills are dropping to strong negative yields.

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