(Bloomberg) -- Five trillion euros of liquidity is eroding the bridge between European interest-rate policy and borrowing costs in money markets, spurring debate over the kind of toolkit needed to stop the dislocation warping the cost of funding in the wider economy.
In normal times, tighter policy at the European Central Bank would be expected to lift money-market rates in tandem, ultimately raising the cost of borrowing more broadly and helping cool inflation. But so-called collateral scarcity -- or a shortage of bonds in the market after years of central bank debt purchases -- means demand is soaring for the limited pool of notes available, keeping yields lower and effectively blocking the transmission of higher ECB rates into the economy.
Calls for action are mounting before the ECB’s monetary-policy decision Thursday. Traders in the central bank’s Money Market Contact Group as well as the International Capital Market Association have expressed their concerns to the ECB and suggested a variety of solutions.
“Normalizing policy rates in a context of €4.7 trillion excess liquidity and collateral scarcity risks further impairing the monetary policy transmission,” said Konstantin Veit, portfolio manager at Pacific Investment Management Co. “We expect the ECB to explore options to better control money market rates” in the medium-term, he said.
While Veit doesn’t expect an announcement imminently, medium term options to soak up excess cash could include debt certificates, issued by the ECB and available for purchase by non-bank market participants, he said.
Traders have also proposed that the central bank creates a tool akin to the Federal Reserve’s reverse repo facility, which borrows money from the system overnight in exchange for securities. Other means to ease the mismatch between cash and bond collateral could include encouraging banks to make early repayments on the ECB’s targeted longer-term refinancing operations, or TLTROs.
“Even a partial repayment of TLTROs in the first half of 2023 will release a significant amount of collateral in the system which should support repo market activity,” wrote Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
ECB Weighs Options to Limit Banks’ Gains From Crisis Loans
Collateral scarcity has emerged as a key challenge for the ECB as it seeks to draw a line under the era of negative interest rates and years of bond-buying.
A key area of friction policy makers are watching are the rates on repurchase agreements, or repos. In the minutes to its last decision, the ECB said its July rate hike achieved only “partial pass-through” to repo rates involving specific German securities, which officials put down to a scarcity of these bonds.
Market volatility has added to the pressure as price swings boost demand for collateral, a problem that could be worsened as the ECB’s key rate continues to rise, according to strategists. Traders see a 92% chance of a second 75-basis-point hike from the ECB at its rate decision on Thursday.
The higher cost of bonds can already been seen in their marked outperformance versus swaps, as investors pile into high-quality collateral.
The ECB already moved to stop a bigger flood of cash chasing limited securities by temporarily scrapping a zero-percent interest cap on government deposits in eurozone central banks. But investors say this won’t be enough to ease pressure in the money market, which ECB Chief Economist Philip Lane calls “central” to the transmission of monetary policy.
Traders Struggle
“My traders are sometimes really struggling,” said Dalibor Jarnevic, head of government bond trading at DZ Bank AG, pointing to the cost of borrowing bonds in repo markets. “This is obviously a market where you can’t trade under economic circumstances, and you can’t give liquidity to the market if you don’t have it.”
Officials and market participants are trying to come up with ideas for a fix.
Ileana Pietraru, global head of short-term treasury at Societe Generale, gave a presentation to ECB officials, including Lane, which concluded that a facility like the Fed’s reverse repo, or RRP, may be required to keep rates in line with the ECB’s deposit rate.
The ECB said that what is discussed at such meetings does “not provide any insight into the intentions of the ECB” in response to a media report that cited the presentation.
According to a separate ECB working paper from August, a central-bank secured facility accessible to a wider pool of market participants could help create a floor for repo rates.
NatWest Markets rates strategist Giles Gale argued other methods are more effective.
“Sterilization bills are in principle a simple, flexible solution or part-solution for the ECB key problems,” he wrote in a note.
And governments themselves can be part of the solution.
The German finance agency last week increased the amount of bonds available for lending in repo markets as a method of short-term financing. That has “clearly supported” the market, DZ Bank’s Jarnevic said.
Ultimately, none of these methods alone will solve the fundamental problem of overwhelming appetite for collateral.
“The appetite for bonds due to risk aversion and scarcity will remain in the market,” said Charles-Henri Baubigeat, head of government bond and SSA trading at Natixis.
Current ECB measures won’t “solve the issue of shortage of collateral -- especially ahead of year-end,” he said.
--With assistance from James Hirai.
(Updates with ICMA letter in third paragraph.)
©2022 Bloomberg L.P.
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