Draghi grapples with money markets showing revival too soon
By Jeff Black & David Goodman
Mario Draghi may need to take action to stop money-market investors getting ahead of themselves.
For the first time since 2008, overnight interbank rates are starting to exceed the European Central Bank’s benchmark interest rate, signaling a return to pre-crisis behavior even as the economy remains fragile. That’s testing the ECB president’s promise that officials are ready to respond to any unwarranted monetary tightening.
While rising market rates could be a sign of normalization against the backdrop of a healing euro-area economy, the risk is that they increase loan costs for companies and households too fast and endanger that recovery. Draghi may steer against exuberance as soon as this week by deploying policies considered since last year, such as ending the absorption of cash from crisis-era bond purchases, according to banks including Societe Generale SA.
“The ECB believes only in a very gradual recovery,” said Anatoli Annenkov, senior European economist at Societe Generale in London. “From that perspective, they’d probably be happy to push money-market rates as low as possible.”
The average cost of overnight, unsecured lending between banks in the euro area was 0.254 percent last month, three times as high as a year earlier. The measure, known as Eonia, spiked to 0.457 percent on April 29, the highest excluding month-end volatility since 2011. The ECB’s main refinancing rate has been at a record-low 0.25 percent since November.
In normal times, when the ECB rations the funds it lends to the system, Eonia hovers just above the benchmark rate as lenders unwilling to pledge collateral for central-bank cash access the financial markets for a small premium. That relationship broke down in October 2008, a month after the collapse of Lehman Brothers Holdings Inc., when the ECB responded to the ensuing cash crunch by offering unlimited funding against eligible collateral.
The cost of 3-month funds, which are more representative of borrowing for the real economy, is also showing a revival. Euribor is about 10 basis points above the ECB’s benchmark rate, the biggest spread since before the central bank injected about 1 trillion euros ($1.4 trillion) into the financial system at the end of 2011 via 3-year loans to banks.
The trend could simply be a sign that banks are becoming less reliant on the ECB as the economy rebuilds, according to HSBC Holdings Plc.
Excess liquidity in the euro-area financial system, or the cash above that needed for normal functioning, has fallen as banks make early repayments of the 3-year loans. The indicator has dropped from more than 800 billion euros in March 2012 to as low as 80 billion euros on April 29. It rebounded to 175 billion euros on May 2.
“As fragmentation in the banking system eases, a decline in excess liquidity should lead the short-end money market rates to converge toward the refi rate, which is what we are witnessing,” said Subhrajit Banerjee, an analyst at HSBC in London. “We do not see imminent pressure on the ECB to act just yet.”
Even so, tighter and more-volatile markets increase the risk of what Draghi has described as a “liquidity accident.” The 30-day historical volatility for Eonia is the highest since at least 2004, an added concern for banks already dealing with a yearlong health-check before the Frankfurt-based ECB takes over supervision duties in November.
Policy makers meet in Brussels on May 8 to set monetary policy amid mixed economic signals and an inflation rate that’s still less than half their goal. In a speech in Amsterdam on April 24, Draghi said any “undue tightening” in the monetary stance could be met with measures including an extension of the policy of granting banks unlimited cash or offering new long-term loans.
Executive Board member Benoit Coeure, who is responsible for market operations, has said the policy of meeting banks’ cash demands in weekly auctions is the most-powerful tool to manage the functioning of the market. The 7-day tender settled on April 30 added more than 50 billion euros to liquidity after the spike in rates the previous day. Eonia dropped to 0.126 percent by yesterday.
The ECB will announce the result of its latest 7-day tender today. It forecasts an allotment of 102.5 billion euros, down from 172.6 billion settled on April 30, because of the drop in market rates over the last few days.
The central bank will also announce the outcome of its weekly liquidity drain related to the Securities Market Program. The operation is intended to mop up cash injected under the SMP, a bond-buying exercise that was started in 2010 as Greece teetered on the edge of bankruptcy. The absorption failed for a third week on April 29, signaling a desire among some banks to hold onto the liquidity.
Halting the weekly drain would add about 170 billion euros to the system, the value of the bonds still outstanding. Policy makers have so far declined to take that step, with Draghi telling reporters in February that the effects would be “relatively limited.”
That provides an argument for other options such as tweaking the marginal lending facility. Cutting the penalty lending rate, currently at 0.75 percent, would lower the effective ceiling for money markets and help rein in the volatility, according to Benjamin Schroeder, a rates strategist at Commerzbank AG in Frankfurt who says excess liquidity should be high enough to provide banks with an adequate buffer.
“The ECB would need to target a daily level of a little above 100 billion euros to keep Eonia steady just below the refinancing rate,” Schroeder said. “The ECB should also increasingly mull over liquidity interventions, such as stopping the SMP tender.”
While the ECB could yet take unprecedented steps such as charging banks to deposit cash overnight, economists view that as unlikely this month. Just two of 53 respondents in a Bloomberg News survey predicted the deposit rate, which has been at zero since July 2012, will be cut. Two out of 58 economists forecast a reduction in the key rate.
“In the past few weeks, we have seen increasing volatility in money markets,” said Christian Reicherter, an analyst at DZ Bank AG in Frankfurt. “Now the ECB needs to decide if they want normalization, or if they have to do something.” [Bloomberg]