Focus - EUR: Excess liquidity and money market rates

In this focus article we first look at upcoming key events for excess liquidity and discuss implications for money market rates. Then we give a brief overview of the subcomponents in the analysis of the euro area liquidity conditions.

Normalisation of excess liquidity and rates

Excess liquidity in the euro area has fallen from more than EUR300bn in June to below EUR50bn for a brief period and as a result EONIA and Euribor rates have increased sharply. It has also increased uncertainty about the future developments in short market rates and thus the focus on the developments in liquidity conditions. On October 27 the ECB allotted EUR42.5bn in a three-month long-term refinancing operation (LTRO). This was EUR19.3bn more than the EUR23.2bn that matured from the three-month LTRO that
was allotted in July. This has increased excess liquidity from around EUR45bn to about EUR65bn and this has put some downward pressure on EONIA rates. EONIA O/N fell from 0.86% on October 26 to 0.85% on October 27, while the decline was more pronounced in the one week EONIA, which fell from 0.79% to 0.70%.

A few key dates

In recent maintenance periods we have seen EONIA rates moving down at the end of the maintenance period, reflecting that banks tend to frontload their fulfilment of reserve requirements. At the beginning of this maintenance period banks’ current account holdings have only been about EUR16bn higher than the average reserve requirement compared with around EUR50bn in the previous maintenance periods. The downward
drift in EONIA O/N, as we move toward November 9, is thus likely to be significantly less pronounced than previously seen – a few quick “back of the envelope” calculations indicate that we should not expect more than 3-4 basis points.

The last extra-long operations mature
Another key date is December 23, when the last 12-month LTRO matures. This LTRO totalled EUR97bn and although a 13 day bridge operation is scheduled we could see a further drain in excess liquidity as we saw when the previous 12-month operations matured in June and September and a resulting further normalisation in money market rates. Indeed EONIA O/N could move close to 1% in the last days of the year.

Next step in the ECB exit strategy
While the FED is discussing further easing the ECB remains focused on its exit strategy. The natural next step for the ECB in its exit strategy is to move from full allotment back to fixed allotment on its refinancing operations. Indeed the ECB sees the decline in excess liquidity as a sign of progressive normalisation in the banking sector (which is a precondition for the ECB to go ahead with its exit).


But Trichet has also called for banks to take appropriate measures to reinforce their balance sheet. So the ECB seem to be concerned that although the sector as a whole is healing there are still individual banks that are not yet ready to cope with an exit from non-standard liquidity measures.

At the current juncture it appears that it is only Bundesbank president Axel Weber who favours an immediate end to non-standard measures. We thus expect that the ECB to keep the exit strategy on pause for a while. We anticipate that Trichet will announce at the press conference on December 2 that they will continue to provide full allotment at longterm refinancing operations (one and three months) in January, February and March and at the main refinancing operations at least until the end of next year’s third refinancing period on 12 April 2011. The shift to fixed allotment will then be announced at the Governing Council meeting on 3 March 2011. The forward market is currently pricing EONIA at 0.97% at mid-April, so this is not far from being aligned with our expectations. We expect that the ECB will begin its hiking cycle with a 25bp hike in November 2011.

A month ago this call was well off compared with the market pricing, but after the recent rate increases the market is now pricing a 50% change for a hike before end-2011.

Excess liquidity and its subcomponents
Below is a short description of the main drivers of developments in the banks excess liquidity. Excess liquidity is calculated as the surplus of liquidity supply over liquidity demand.

The liquidity supply in the euro system mainly consists of the ECB’s main refinancing operations (MRO) and long-term refinancing operations (LTRO). Prior to the financial crisis these auctions where variable rate fixed allotment tenders – i.e. the ECB decided the amount to be allotted. Since October 2008 there has been full allotment at all auctions – i.e. the banks decide how much liquidity they want. The demand for liquidity at LTROs has fallen dramatically as the duration of the longest LTROs has fallen from one year to three months as part of the ECB’s exit strategy for non-standard measures.

Other operations (OT), including the euro liquidity effect of the foreign exchange swap operations, also affect total liquidity supply and is included in total open market operations. The ECB also displays the liquidity effect of the covered bond portfolio under open market operations.

The ECB announced a benchmark allotment for the MROs, both at the time of the announcement and the allotment. When the ECB returns to fixed allotment the ECB calculations of the benchmark allotment will again form the basis for the amount offered at the weekly auctions. The amount offered at the three-month LTROs was fixed at EUR50bn prior to the crisis. There was no one-month LTRO prior to the crisis and it is
likely to be phased out when the ECB shifts to fixed allotment. The termination of the one-month LTROs in itself should not have any significant market impact.
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