Rates Spark: Changing the rules of the game

Two things have happened in the past couple of days.

First the structure of the curve has flipped toward a more bullish leaning as the 5yr has resumed an outperformance on the curve as market rates have fallen. This is typical as the market starts to converge on a likely completion of the rate hiking process.

Second, the market discount for the terminal rate itself has eased off from the highs. A few days back the fed funds strip was peppering the 5% area. Its now back down to 4.85%. That pulls down the need for the 10yr to ratchet higher.

The 10yr had been at 4.25%, and looking up. It’s now closer to 4%, pulled there in part by a slew of weak macro data, and talk that the Fed may be about to ease off on the size of hikes once they deliver the 75bp discounted for November. But there is something else going on too.

Sneaky item three. Bank funding costs are now creeping higher.

The 3mth commercial paper rate is up to 25bp over the risk free rate, and double that for European names. That’s the beginning of signs of creaking in the system. If the Fed is going to pull back in the face of persistent inflation it is more likely to reflect this than the macro weakness that, after all, they are actively engineering. No panic yet. Just something to monitor.

Probably enough there to keep the 10yr above 4% for now, and for it to continue to be re-pressured higher in the weeks ahead. But we are also looking at 4.25% as being quite peakish (with an outside risk to 4.5%). Can’t quite conclude that the 4.25% seen was in fact the high, but these are the things we are looking at.

Heading into tomorrow’s ECB meeting, various press reports have put changing the terms of TLTRO loans to banks as the ECB’s favourite option. The goal is to nudge them to repay, and to reduce a perceived subsidy paid to banks that can currently place these funds back at the ECB at a higher interest rate than they borrowed. As we’ve outlined in earlier publications, all options on the table are potentially disruptive but the central bank seems intent on acting before TLTRO loans fall due, the majority of them as soon as June next year. The question now is what change the ECB will implement.

The central bank seems intent on acting before TLTRO loans fall due

Changing the borrowing rate from “average interest rate on the deposit facility calculated over the life of the respective TLTRO III during the rest of the life of the same operation” to “average interest rate on the deposit facility calculated over the rest of the life of the respective TLTRO III during the rest of the life of the same operation” would make the borrowing rate identical to the rate at which the proceeds are placed back at the ECB, and eliminate the carry trade opportunity.

This wouldn’t guarantee immediate repayment of TLTRO loans, however. Likely, these funds have been earmarked by banks for other uses already, and it is probable that some banks don’t have the liquidity available to repay the ECB at the next opportunity in December 2022. Given funding difficulties over year-end some may choose to wait for March 2023 for their early repayments. Finally, we expect other banks would hold on to their TLTRO loans until their maturity given challenging funding environment currently. In the chart below, we illustrate the difference between this early repayment scenario and the original maturities of TLTRO loans.

This wouldn’t guarantee immediate repayment of TLTRO loans

Of course, the ECB could be more aggressive and add a spread on top of the average interest rate on TLTRO loans to incentivise earlier repayments. This is an option it might pursue if a sharp reduction in excess liquidity is its goal but we think it is far from guaranteed to work, and would end up punishing banks with the most difficulties in accessing funding markets. The other, apparently more important, objective of getting rid of the perceived subsidy to banks, can be achieved without causing such disruptions as desribed above. By this simple change, up to €31bn of interest cost to the ECB disappear.