Trading wisdom has always been that the main driver
of the front end of the Eonia and Euribor futures curves was
the European Central Bank’s monetary policy
stance. The Euribor futures contracts had embedded in their
prices the probability of the ECB raising or lowering rates.
Using the Euribor strip we could therefore determine the
market’s view of the probabilities of different
rate moves by the ECB.
This was perfectly adequate as long
as the market operated smoothly. Normally, banks use the
interbank overnight market to satisfy their short term
liquidity needs and legal reserve requirements. The ECB uses
its weekly Main Re?nancing Operation (MRO), consisting of seven
day repo lending, and other policy tools to steer rates towards
its official Repo rate.
During these normal times, Eonia
fixings hovered some 6bp-8bp above the ECB's Repo rate, and
three month deposit money – basically, three month
Euribor – cost around 25bp more than the Repo
But since the collapse of Lehman
Brothers, the times have not been normal. The
ECB’s intentions have changed, with the main
emphasis given to supporting a fragile banking sector. The
simple relationships and correlations of the past have been
broken and short term interest rates (Stirs) traders need to
consider the new drivers of their market.
New drivers for rates
In response to the credit crisis and
the seizing-up of the overnight interbank market, the ECB had
to step in and provide liquidity to support bank balance
sheets. Banks no longer trusted each other, and those with
excess liquidity preferred the relative safety of depositing it
at the ECB over taking the risk of lending it out in the
As the liquidity in the interbank
market dried up, Euribor rates were driven much higher, even as
the ECB initiated a fast rate-cutting cycle. The ECB responded
to this interbank market collapse by ?ooding the market with
liquidity in the form of full allotments in its Open Market
Operations (OMOs). Full allotment meant that the ECB would lend
?nancial institutions as much money as they asked for, provided
they had suf?cient highly rated collateral to support it. It
also introduced one month, six and 12 month Long Term
The ECB then went a step further and
softened the collateral rules. It even announced that it would
accept Greek government bonds irrespective of any rating
The Bank further introduced a
Securities Market Programme, under which, for the first time,
it bought securities outright instead of lending through repos.
This undermined the no intervention and no bail-out policy of
the ECB’s constitution.
All these forms of lending by the
ECB are summed up by the Bank in a weekly report, which tracks
'excess liquidity’ – the difference
between how much money the ECB estimates the Eurosystem
requires and how much the Bank actually supplies.
If a bank runs out of acceptable
collateral, national governments such as those of Greece and
Ireland have been stepping in, providing credit guarantees to
enhance the quality of the collateral and thus make it
repo-able with the ECB.
Contrary to popular belief, the ECB
cannot play the traditional role of lender of last resort for
the Eurosystem banks. This is left to the national central
banks of each country. Ireland, for example, supported its
banks to the tune of €70bn. This so-called Emergency
Liquidity Assistance (ELA) is not part of the Eurosystem and is
thus not shown as excess liquidity in the weekly ECB report,
but is hidden in what is called 'autonomous
Awash with cash
The excess liquidity provided by the
ECB in its full allotment weekly OMOs altered the dynamics of
the interbank market (see graph).
Either fearing another credit
crisis, or because they were conscious of their fragile
finances, banks overborrowed from the ECB. Now they had more
cash than their legal reserve requirements and could either
deposit the excess with the ECB, earning the deposit rate at
0.25%, or ?nd a trustworthy ?nancial institution to lend to
Lending it to corporate or retail
borrowers was seen as hazardous and would further inflate their
impaired balance sheets. Incidentally, this is one of the
reasons that inflation has remained relatively low, despite the
massive injection of cash. Simply put, the cash never reached
the wider consuming public but stayed within the confines of
the interbank system.
As the Repo rate was lowered to 1%,
banks saw losing 75bp (the difference between borrowing at the
Repo rate of 1% and lending back to the ECB at 0.25%) as an
acceptable price to pay for securing peace of mind.
The system had hundreds of billions
of euros of excess cash and Eonia ?xings were driven down below
the of?cial Repo rate, to just a few basis points above the
deposit rate (see graph). Euribor, too, fell below the Repo
rate. Thus Eonia and Euribor levels have become a function of
the amount of excess liquidity in the system.
The total amount of liquidity
provided by the ECB in its weekly OMOs has now become the main
driver of Eonia and Euribor.
The ECB’s reserve
requirement – to maintain cash deposits at the ECB
covering at least 2% of short term liabilities – is
calculated as an average over time. Banks do not have to comply
with it every night, but must fulfil it on average, over a
'maintenance period’ of three to four
Banks have been taking advantage of
this by using the excess liquidity in the system to frontload
their reserving at the beginning of the maintenance period.
Thus, early in the maintenance period most banks place plenty
of excess cash on deposit with the ECB at 0.25%, building up
their reserves to fulfil the requirement for the whole period.
This starves the interbank market of cash and drives Eonia
As the maintenance period
progresses, Eonia fixings drift lower as more banks reach their
reserve targets and feel free to lend the excess to the
interbank market. Meanwhile, Euribor stays at a fairly constant
spread over Eonia.
Let’s contrast this
with what normally happens when the ECB is not practising full
allotment and banks feel safe using the interbank market. Banks
begin the maintenance period by estimating their liquidity
needs and use the interbank market to fulfil them. They
don’t feel the need to overborrow from the ECB
since this incurs a loss of 75bp.
Cash is readily available in the
interbank market and Eonia starts from a low base. As the
maintenance period nears its end, banks scramble to fill their
last minute needs or miscalculations and this drives Eonia
It is clear that the actions of the
ECB in managing the crisis have altered the behaviour of
banks’ treasury operations and in the process
changed the dynamics of the short end of the curve.
Thus, the weekly ECB liquidity
report has now become the Bible of Stirs traders and new words
have entered the trading vocabulary like OMOs, ELA and
autonomous factors (liquidity not directly controlled by the
Normalisation, one step at a
On April 7, the ECB raised its main
rates by 25bp, to 0.5% for the deposit rate, 1.25% for the Repo
rate and 2% for the Marginal Lending Facility – the
beginning, perhaps, of normalising the money
Since this move had been signalled
at the Bank’s March meeting through the use of the
phrase "strong vigilance", the market was prepared for the move
in rates. The only surprise was the ECB’s decision
to retain a 150bp corridor between deposits and the MLF. Before
the crisis that spread was 200bp.
Despite the rate rise, the ECB will
continue full allotment in its OMOs until the end of the second
quarter and may decide to extend it for as long as it considers
The Bank had little choice about
this policy. It is committed to maintaining its reputation as
hawkish on inflation, and with inflation threatening to get out
of hand, a rate rise was the only way to do that.
At the same time, the ECB
understands the weakness of the banking sector, especially in
peripheral countries where the governments are struggling to
finance their budgets, such as Greece, Ireland and
Worried about contagion to other
countries such as Spain and Italy, the ECB is now juggling
higher official rates while simultaneously providing excess
liquidity, which has a tendency to depress both Eonia and
Euribor below the official target rate.
If the ECB ends full allotments and
goes back to the normal bidding process for funds, banks in
peripheral countries would likely bid aggressively for the
money available, leading to significantly higher Eonia and
Euribor fixings than in the past, relative to the official Repo
This could even trigger a new
banking crisis, which is why the ECB is simultaneously
providing both full allotment and higher rates.
This bind is probably also
responsible for its maintenance of the 150bp corridor. The
deposit rate acts as a floor for overnight interbank rates, and
widening the corridor would have left it at 0.25%. That could
have negated the rate-raising power of lifting the Repo rate
from 1% to 1.25%.
In conclusion, it is important to
realise that Eonia and Euribor, which used to be determined by
ECB monetary policy under normal circumstances, before being
governed by the huge amount of excess liquidity in the system
during the crisis, are now about to change again. As the ECB
attempts to lift the extraordinary measures taken during the
crisis, the market is trying to read the changes, and find some
way of repricing Eonia and Euribor to reflect the gradual
return to normality.
The main driver of their prices has
become the ECB liquidity report, which indicates how much money
is being deposited at the central bank to cover reserve
requirements and how much has been deposited at the ECB deposit
As long as full allotment persists,
the main governors of Stirs prices will be the excess liquidity
report and the size of the deposit at the ECB.
ITC Markets provides specialised
news and analysis for fixed income and equities traders,
including a weekly report on the ECB’s Main
Refinancing Operation. For a more in depth analysis on central
banks and liquidity, contact the authors at email@example.com.