The Business Times

Lagging repo rates risk undermining ECB’s latest tightening push

Published Sat, Sep 17, 2022 · 11:56 AM

A shortage of high-quality assets in the euro area is keeping a lid on short-term borrowing costs, a development that could endanger the European Central Bank’s (ECB) effort to tighten financial conditions.

The cost of borrowing cash against German government bonds in repo markets, where dealers and funds look for short-term financing, has only climbed 57 basis points since the ECB’s decision to raise rates by 75 basis points last week, according to data from Commerzbank.

It’s a symptom of years of central bank bond-buying that has helped inflate the amount of excess money in the system to a record 4.7 trillion euros (S$6.6 trillion) and reduced the stock of government bonds available to trade. The imbalance wasn’t a problem when the ECB was keeping financial conditions loose, but now it means too much cash is chasing a limited number of securities, acting as a damper on rates.

“The shaky and uneven pass-through is a major concern,” said Michael Leister, a rates strategist at Commerzbank. “Recent developments in repo markets raise the risk of another intervention by the ECB.”

Officials have said they are monitoring the situation to ensure that interest-rate rises are actually feeding through to lending rates and the broader economy. The central bank did act to prevent conditions further deteriorating at its last meeting, temporarily lifting an interest-rate cap on government deposits, a move designed to curb demand for securities such as short-dated notes.

Yet demand for high quality securities has been amplified by volatility sweeping across markets this year. Traders grappling with an uncertain path of inflation and rates have flocked to these securities to ride out the storm.

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Repo market pricing is still choppy as markets adjust to the ECB’s changes, but already the reaction looks different to that seen following the previous 50 basis-point hike in July. Then, it was primarily repo rates for transactions using specific securities as collateral that remained lower.

Now, the dynamic has spread to deals that can use a broad pool of different government securities to lend against, as well as transactions that use French and Italian securities, according to Commerzbank.

Other lending rates, such as the euro short-term rate (ESTR), which is based on banks’ unsecured overnight borrowing costs, did react more fully to the hike, fixing 74.5 basis points higher. Some analysts had been concerned that the spread between ESTR and the ECB’s deposit rate could diverge further on a jumbo hike, which would have more significant impact for monetary policy transmission.

ECB chief economist Philip Lane said the ESTR rate was “especially important”, given it underpins gauges used to determine market expectations of future central bank policy, and that officials would also “remain attentive to the spread between different money market rates as well as collateral scarcity concerns” in a speech on Wednesday (Sep 14).

Prior to the ECB’s decision to temporarily scrap the interest-rate cap on government deposits, 2-year German bonds traded at the largest premium to swaps since 2008. Traders were bracing for government cash to leave central bank coffers and head into high-quality securities.

While this pressure has eased, these bonds are still trading at their most expensive versus swaps in around a decade. The swap rates have been driven higher by companies, banks and other investors hedging against future interest-rate hikes.

“What the ECB has not addressed, however, is the initial collateral shortage,” said ING Groep strategists including Antoine Bouvet in a note to clients. “Lane’s speech was also a reminder that collateral scarcity issues will remain.” BLOOMBERG

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