Commentary:
We saw some wholesale, panic liquidation in Euribor futures today. The front March contract dropped 8bps and is now a full 12bps above today’s Euribor settlement rate. The white Dec contract sold off 15bps, and is now 30bps above spot. The moves in Europe have impacted US money market rates as well. The fear is around the LTRO prepayment option coming up at month end. A large prepayment could reduce the 3m Euribor – Refi rate spread, which is currently at -55bps.
Currently there is >600bn in zero maturity excess liquidity sitting at the ECB, earning nothing. Much of this is from the 3 year LTRO conducted by the ECB a year ago, on which EU banks are paying 75bps. This liquidity was cheap a year ago, when 5y EU financials CDX was trading at almost 300bps over swaps, and deposits were leaking out of periphery banks like water from a sieve. However, funding conditions are now much easier, as 5y unsecured spreads are now back to mid 2010 levels. For banks in France and Germany, 2y funding costs of posted collateral + 75bps is quite expensive, considering that repo rates for French and German bonds are just above zero and the threat of bank failures have decreased sharply.
Historically, the level that Euribor trades relative to the ECB Refinance and Deposit rates is driven by the amount of excess liquidity in the system. In the past, when excess liquidity is above 100 or 200bn, Eonia (which drives Euribor) has traded close to the ECB deposit rate. So a lot of LTRO money would need to be paid back before Euribor fixings start to rise. But as the chart above shows, CDS levels are consistent with a large paydown. (It is worth noting that CDS levels certainly do not tell the whole picture. EU banks, like EU countries, face very bifurcated funding conditions, and CDS only trades on large, strong EU banks. This means CDS levels probably overstate the improvement in aggregate EU bank funding conditions)
Also worth considering is that the rise in Euribor the past several weeks has been substantial. 2 year Euro swap yields are now ~30bps higher and almost 2x early Dec levels. That is a substantial jump and probably not one that the ECB is especially happy about. An increase of the 2y swap rate above the 75bp refinance rate is likely to unleash some additional ECB policy easing, (probably starting with some verbal jawboning) given that Draghi said the following things just a week ago:
- The risks surrounding the economic outlook for the euro area remain on the downside.
- economic weakness in the euro area is expected to extend into 2013.
- necessary balance sheet adjustments in financial and non-financial sectors and persistent uncertainty will continue to weigh on economic activity
- our accommodative monetary policy stance, together with significantly improved financial market confidence and reduced fragmentation, should work its way through to the economy,
The emphasis on downside risks, persistent uncertainty, and financial market fragmentation is significant, because ultimately, higher Euribor rates worsen all those factors.
Current Euribor levels price in a reversion to the current refi rate of 75bps by 1Q 2015, but on a somewhat linear basis. That’s probably unlikely. As the 2nd chart above shows, Euribor settlements are only likely to rise if excess liquidity declines below 200bn. So a more likely scenario is that Euribor settlements stays low until that occurs, then moves higher quickly. The chart below shows how Euribor settlements likely to change in a scenario where excess liquidity is reduced by 15% each quarter. Implied Yield is the estimated Euribor settlement based on the Excess Liquidity Assumption. I assume 3m Euribor will settle at 25bps if there is sufficient excess liquidity, vs 20bps now. In this scenario Euribor whites and reds offer significant value.
Even if LTRO payments are incredibly heavy, (let’s say 200bn every quarter, vs consensus estimates of 200bn thru the end of Q2) the front two Euribor contracts appear cheap:
Two final points. First, I have a hunch that one reason the ECB is reluctant to cut the Refi rate further is that it would spur massive repayment of the LTRO loans and introduce significant volatility into the European money markets. However, if banks voluntarily repay the LTRO loans, the ECB is likely to be more willing to cut the refi rate. Second, CTA liquidation is a likely key driver behind today’s move. Euribor futures have had an attractive momentum to volatility ratio for a long time – but both momentum (yellow) and volatility (green & purple) has reversed, and CTAs are likely all trying to get out at the same time. It isn’t clear if we’ve gotten to the capitulation point yet, but we’re probably not far away.
Notable:
- US Jobless Claims dropped to 335k last week vs 369k exp and 371k prev
- US Philly Fed declined to -5.8 in Jan vs +5.6 exp and +4.6 prev
- US Housing Starts jumped to 954k last month vs 890k exp and 861k prev. However, Building Permits were broadly inline.
- Reports that Fed officials are voicing increased concern that asset prices are overheating drive a sell of in money market rates overnight.
- BoA and Citi both missed expectations. Blackrock beat by a wide margin.
- Australia Employment dropped -5.5k in Dec vs 4k exp and 13.9k prev. Unemployment increased to 5.4% as exp vs 5.2% prev
- Japan headlines:
- LDP considering plans to raising top tax bracket to 45% from 40%
- BoJ may scrap 0.1% rate floor
- Nikkei reports BoJ will hike the APP by 10trn and keep APP open ended until 2% target is hit.
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- Mon: BoJ
- Tue: German ZEW, US Existing Home Sales, Australia CPI
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