EUR money markets: More liquidity, more compression

The ECB's pledge “to recalibrate” its instruments in December, with all of them on the table, was widely interpreted as a pre-commitment to act decisively. If it takes the shape our economists anticipate, high and rising excess liquidity levels will remain a dominant feature in 2021. ECB President Christine Lagarde hinted as much at her latest speech at the Central Banking Forum, highlighting that the TLTRO (liquidity injections to banks) and PEPP (asset purchases) would likely remain important tools to bridge the gap until a wider vaccine rollout opens a path back to normalcy later in 2021.

Depressed rates will remain a feature for longer than anticipated

Indeed, we see little to be gained from an even lower deposit facility rate. And the market is already anticipating yet more quantitative easing. Given that borrowing from the ECB is likely to become even more attractive, banks’ financing needs from the markets, at least in the short term, should decline further. This substitution has been instrumental in the decline of unsecured rates such as Euribor fixings and commercial paper rates in our view. The corollary to an extension of the TLTRO’s low-interest rates terms, and higher take up, would be that depressed rates remain a feature of markets for longer than anticipated. This should push Euribor forward rates, relating to 2021 and 2022, lower.

That said, 3M Euribor fixings are now below the deposit facility rate of -0.5%. We believe that the overnight €STR rate currently fixing around -0.56% should mark the lower bound for Euribors in the absence of ECB rate cut speculation, as it reflects what banks charge for the service of redepositing at the ECB. Being aware that the negative rate charged on ever-higher excess liquidity is a cost to banks, there is a chance that the ECB will allow them to redeposit a larger portion of their liquidity at 0%. This tiering multiplier could be increased, but not to a degree that would materially change money market dynamics. It remains that the marginal cost for any added euro of excess liquidity, i.e. the deposit facility rate - should determine the market rate.

Rate cut speculation is probably the main determinant of outright money market rate movements. At the moment, the market attaches a non-negligible chance that the ECB will lower the deposit facility further. €STR forwards rates for the end of next year are at -0.61%. This implies that if we are right that the ECB will not follow through with cuts, these rates are still prone to correct higher. Albeit only moderately so - the economic outlook for sure does not warrant a rate hike within the next couple of years - we thus believe the pressure exerted by excess liquidity and the TLTROs on rates is more likely to manifest itself in a further compression of money market spreads such as the difference between Euribor and €STR.