Rates Spark: Third wave gloom

Over the course of yesterday 10Y US Treasury yields climbed steadily from below 1.6% to above 1.63%, a small pullback coming only after a decent 5Y auction eased fears over the actual disruption caused by the Fed's SLR decision last week. EUR rates were able to decouple from the uptrend, ending their day little changed versus the open at near -0.36% in 10Y. The spread versus UST rewidened to near 200bp again.

There was some volatility and push higher in yields on the back of much better than anticipated PMI readings. But the data for the flash survey was largely collected ahead of the recent lockdown extensions which risk further delaying the economic rebound. The positive PMIs were eventually outweighed by concerns over still rising infection rates. Of course, the ECB buying more via the pandemaic emergency programme (PEPP) in the background should have helped.

Yesterday saw the settlement of the ECB's latest targeted longer-term refinancing operation, the seventh TLTRO.III tranche. €331bn arrived in banks’ accounts and added to overall excess reserves in the banking system, pushing these closer to €4tn. The TLTRO should further reduce banks’ financing needs in other (short term) markets. In the past this substitution has been instrumental in the decline of Euribor fixings in our view and a revisit of fixing lows would not surprise against that backdrop.

Excess reserves will continue to grow as more than €900bn remains to be spent of the ECB's PEPP envelope in the coming three months at an accelerated rate of €60-100bn per month. This comes on top of regular asset purchases of €20bn per month and the three more TLTRO tranches still scheduled. Currently excess reserves incur a penalty of -0.5% that the ECB charges for any reserves that exceed a bank’s minimum reserve requirement plus an allowance that currently amounts to 6 times the minimum requirement. The allowance had been introduced by the ECB in 2019 to lessen the burden of excess liqudity on banks, and one might think raising the multiplier above 6 is overdue.

At this junction one should note that the TLTROs are provided to banks at a subsidy rate of as low as -1%, provided that certain lending benchmarks are met. Currently the subsidy provided via the TLTROs on aggregate should outweigh the penalty incurred on banks’ excess reserves. The ECB provides some country-level data for the distribution of excess liquidity including those amounts incurring the penalty. We can set that against the distribution of the longer term operations - at the moment not including the latest tranche.

By the end of January – the latest available data point - Germany was saddled with the largest amount of excess reserves, €601bn incurring the -0.5% penalty rate. At the same time German banks also had more than €340bn in LTROs outstanding, most of it in TLTROs which can “earn” them a rate of up to 1%, thus likely compensating for the cost of excess reserves. However, the setup is particularly beneficial for Italian and Spanish banks with low excess reserves but high TLTRO participation. Overall we conclude that increasing the tiering multiplier is unlikely to be the most pressing issue in the eyes of the ECB at the moment.