Trading wisdom has always been that the main driver of the front end of the Eonia and Euribor futures curves was the European Central Bank’s monetary policy stance. The Euribor futures contracts had embedded in their prices the probability of the ECB raising or lowering rates. Using the Euribor strip we could therefore determine the market’s view of the probabilities of different rate moves by the ECB.

This was perfectly adequate as long as the market operated smoothly. Normally, banks use the interbank overnight market to satisfy their short term liquidity needs and legal reserve requirements. The ECB uses its weekly Main Re?nancing Operation (MRO), consisting of seven day repo lending, and other policy tools to steer rates towards its official Repo rate.

During these normal times, Eonia fixings hovered some 6bp-8bp above the ECB's Repo rate, and three month deposit money – basically, three month Euribor – cost around 25bp more than the Repo rate.

But since the collapse of Lehman Brothers, the times have not been normal. The ECB’s intentions have changed, with the main emphasis given to supporting a fragile banking sector. The simple relationships and correlations of the past have been broken and short term interest rates (Stirs) traders need to consider the new drivers of their market.

New drivers for rates

In response to the credit crisis and the seizing-up of the overnight interbank market, the ECB had to step in and provide liquidity to support bank balance sheets. Banks no longer trusted each other, and those with excess liquidity preferred the relative safety of depositing it at the ECB over taking the risk of lending it out in the interbank market.

As the liquidity in the interbank market dried up, Euribor rates were driven much higher, even as the ECB initiated a fast rate-cutting cycle. The ECB responded to this interbank market collapse by ?ooding the market with liquidity in the form of full allotments in its Open Market Operations (OMOs). Full allotment meant that the ECB would lend ?nancial institutions as much money as they asked for, provided they had suf?cient highly rated collateral to support it. It also introduced one month, six and 12 month Long Term Refinancing Operations.

The ECB then went a step further and softened the collateral rules. It even announced that it would accept Greek government bonds irrespective of any rating downgrades.

The Bank further introduced a Securities Market Programme, under which, for the first time, it bought securities outright instead of lending through repos. This undermined the no intervention and no bail-out policy of the ECB’s constitution.

All these forms of lending by the ECB are summed up by the Bank in a weekly report, which tracks ‘excess liquidity’ – the difference between how much money the ECB estimates the Eurosystem requires and how much the Bank actually supplies.

If a bank runs out of acceptable collateral, national governments such as those of Greece and Ireland have been stepping in, providing credit guarantees to enhance the quality of the collateral and thus make it repo-able with the ECB.

Contrary to popular belief, the ECB cannot play the traditional role of lender of last resort for the Eurosystem banks. This is left to the national central banks of each country. Ireland, for example, supported its banks to the tune of €70bn. This so-called Emergency Liquidity Assistance (ELA) is not part of the Eurosystem and is thus not shown as excess liquidity in the weekly ECB report, but is hidden in what is called ‘autonomous factors’.

Awash with cash

The excess liquidity provided by the ECB in its full allotment weekly OMOs altered the dynamics of the interbank market (see graph).

Either fearing another credit crisis, or because they were conscious of their fragile finances, banks overborrowed from the ECB. Now they had more cash than their legal reserve requirements and could either deposit the excess with the ECB, earning the deposit rate at 0.25%, or ?nd a trustworthy ?nancial institution to lend to overnight.

Lending it to corporate or retail borrowers was seen as hazardous and would further inflate their impaired balance sheets. Incidentally, this is one of the reasons that inflation has remained relatively low, despite the massive injection of cash. Simply put, the cash never reached the wider consuming public but stayed within the confines of the interbank system.

As the Repo rate was lowered to 1%, banks saw losing 75bp (the difference between borrowing at the Repo rate of 1% and lending back to the ECB at 0.25%) as an acceptable price to pay for securing peace of mind.

The system had hundreds of billions of euros of excess cash and Eonia ?xings were driven down below the of?cial Repo rate, to just a few basis points above the deposit rate (see graph). Euribor, too, fell below the Repo rate. Thus Eonia and Euribor levels have become a function of the amount of excess liquidity in the system.

Playing averages

The total amount of liquidity provided by the ECB in its weekly OMOs has now become the main driver of Eonia and Euribor.

The ECB’s reserve requirement – to maintain cash deposits at the ECB covering at least 2% of short term liabilities – is calculated as an average over time. Banks do not have to comply with it every night, but must fulfil it on average, over a ‘maintenance period’ of three to four weeks.

Banks have been taking advantage of this by using the excess liquidity in the system to frontload their reserving at the beginning of the maintenance period. Thus, early in the maintenance period most banks place plenty of excess cash on deposit with the ECB at 0.25%, building up their reserves to fulfil the requirement for the whole period. This starves the interbank market of cash and drives Eonia high.

As the maintenance period progresses, Eonia fixings drift lower as more banks reach their reserve targets and feel free to lend the excess to the interbank market. Meanwhile, Euribor stays at a fairly constant spread over Eonia.

Let’s contrast this with what normally happens when the ECB is not practising full allotment and banks feel safe using the interbank market. Banks begin the maintenance period by estimating their liquidity needs and use the interbank market to fulfil them. They don’t feel the need to overborrow from the ECB since this incurs a loss of 75bp.

Cash is readily available in the interbank market and Eonia starts from a low base. As the maintenance period nears its end, banks scramble to fill their last minute needs or miscalculations and this drives Eonia up.

It is clear that the actions of the ECB in managing the crisis have altered the behaviour of banks’ treasury operations and in the process changed the dynamics of the short end of the curve.

Thus, the weekly ECB liquidity report has now become the Bible of Stirs traders and new words have entered the trading vocabulary like OMOs, ELA and autonomous factors (liquidity not directly controlled by the ECB operations).

Normalisation, one step at a time

On April 7, the ECB raised its main rates by 25bp, to 0.5% for the deposit rate, 1.25% for the Repo rate and 2% for the Marginal Lending Facility – the beginning, perhaps, of normalising the money markets.

Since this move had been signalled at the Bank’s March meeting through the use of the phrase “strong vigilance”, the market was prepared for the move in rates. The only surprise was the ECB’s decision to retain a 150bp corridor between deposits and the MLF. Before the crisis that spread was 200bp.

Despite the rate rise, the ECB will continue full allotment in its OMOs until the end of the second quarter and may decide to extend it for as long as it considers necessary.

The Bank had little choice about this policy. It is committed to maintaining its reputation as hawkish on inflation, and with inflation threatening to get out of hand, a rate rise was the only way to do that.

At the same time, the ECB understands the weakness of the banking sector, especially in peripheral countries where the governments are struggling to finance their budgets, such as Greece, Ireland and Portugal.

Worried about contagion to other countries such as Spain and Italy, the ECB is now juggling higher official rates while simultaneously providing excess liquidity, which has a tendency to depress both Eonia and Euribor below the official target rate.

If the ECB ends full allotments and goes back to the normal bidding process for funds, banks in peripheral countries would likely bid aggressively for the money available, leading to significantly higher Eonia and Euribor fixings than in the past, relative to the official Repo rate.

This could even trigger a new banking crisis, which is why the ECB is simultaneously providing both full allotment and higher rates.

This bind is probably also responsible for its maintenance of the 150bp corridor. The deposit rate acts as a floor for overnight interbank rates, and widening the corridor would have left it at 0.25%. That could have negated the rate-raising power of lifting the Repo rate from 1% to 1.25%.

In conclusion, it is important to realise that Eonia and Euribor, which used to be determined by ECB monetary policy under normal circumstances, before being governed by the huge amount of excess liquidity in the system during the crisis, are now about to change again. As the ECB attempts to lift the extraordinary measures taken during the crisis, the market is trying to read the changes, and find some way of repricing Eonia and Euribor to reflect the gradual return to normality.

The main driver of their prices has become the ECB liquidity report, which indicates how much money is being deposited at the central bank to cover reserve requirements and how much has been deposited at the ECB deposit facility.

As long as full allotment persists, the main governors of Stirs prices will be the excess liquidity report and the size of the deposit at the ECB.

ITC Markets provides specialised news and analysis for fixed income and equities traders, including a weekly report on the ECB’s Main Refinancing Operation. For a more in depth analysis on central banks and liquidity, contact the authors at training@itcmarkets.com.