Recap 1-28-13: Fair Value for Euribor Term Structure

Commentary:

The Euribor curve continued to steepen today, with the whites / reds (1y / 1y, 1yr forward) spread steepening 5.5bps to ~32bps. With Friday’s LTRO announcement over, market participants are trying to find the market clearing level for the money market yield curve.

Typically, the 3rd vs 7th contract trades at a wider spread compared to say, the 2nd vs 6th contract, as the market prices in an additional term premium given the longer duration. However, with the uncertainty around how the LTRO repayments will affect Euribor settings, that differential has closed. (chart below)

The question now is, where ‘fair value’ for these curves should be. There’s no way to tell with certainty, so perhaps it’s best to think about what an appropriate range is, and go from there. This is purely a thought experiment – my attempt to think through the various moving parts. For simplicity, we will assume that the ECB does not hike or cut over the next 3 years.

The low case is fairly straight forward. If EU banks stop paying back the LTRO’s, then liquidity remains plentiful, Libor settings remain broadly unchanged, and whites/reds could converge back to ~10bps or so. On the high side, EU banks could pay back everything by the end of the year, which means 3m Euribor goes from ~25bps now to the Refi rate + ~10bps = 85bps by early 2014. That’s a spread of ~60bps.

Obviously, both cases are a bit extreme, so let’s try to tighten that range a bit. We can start with some possible scenarios for how Euribor settles could change over time, assess some probability weights on them, and compare the probability weighted average to market levels. Obviously, that approach is subject to the ‘garbage in, garbage out’ risk, but it’s a start. For this exercise, I assumed 4 scenarios, and assigned the probability of 20% to each of the scenarios where Euribor rises quickly, and 30% to the 2 scenarios where Euribor rises more slowly.

Interestingly, the probability weighted projected term structure is quite similar to market levels. The market premium over the projected term structure even increases with lengthening maturities, which also makes sense. The only part of the term structure that doesn’t line up if the back end – the Sept and Dec 2014 contracts. This is partially a result of the fact that I put low probabilities on the scenarios that Euribor rises quickly, but the differential still exists if we weight each scenario equally. When we add the fact that money market curves should have higher term premiums the longer we go out, the mispricing becomes clearer. While the March 13/14 and June 13/14 spreads looks reasonably close to ‘fair’ here, (they should probably be ~10bps higher to reflect normal ‘term premium’) the Dec 13/14 spread looks quite low.

Note that the Dec 2014 contract is trading above a yield of ~90bps. In other words, it is pricing in an actual ECB hike of the refi rate. However, part of that term premium SHOULD exist. The Dec 2014 Eurodollar contract, for example, is trading at a 38bp premium to today’s 3m $Libor settle. An equivalent term premium for the Euribor contract would send it to 85 + 38=1.23% yield.

Notable:

  • US Durable Goods jumped 4.6% MoM in Dec vs 2.0% exp on the back of defense and aircraft components. Still, Core Capital Goods Orders rose +0.2% vs -0.2% exp.
  • US Pending Home sales dropped to 4.9% YoY in Dec vs 11.5% exp and 8.9% prev. All regions except the Midwest dropped sharply.
  • Fitch said temporary suspension of debt limit removes the near-term risk to the U.S. AAA rating.
  • ECB’s Coene: “The ideal situation would be for the OMT never to be used…It’s like a nuclear deterrent. Whenever you use it, that will raise new questions and new issues,”
  • Citi’s US Bank Newsletter: deposit flows are much stronger than lending flows, so the deposits that do not go to fund loans have to go to the Fed as excess reserves or into bonds
  • ECB Money Supply Data:
  1. Spanish banks reported a positive net 4bn of deposits, with strong retail & corporate inflows offset by government & pension fund outflows. Retail deposits grew for the 4th consecutive month
  2. Italian customer deposits grew by 54bn
  3. Irish, Greek and Portuguese deposit flows all showed continued stability (all within +/- €1 bn).

Upcoming Data:

  • Tue: US Home Price Index, Consumer Confidence,
  • Wed: EU Consumer Confidence, US ADP Employment, FOMC
  • Thu: ECB LTRO payment begins
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