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Friday, 3 January 2014

Three liquidity scenarios after the year-end.

There are 3 main scenarios that could develop in the liquidity and money market in the €-area at the beginning of 2014, after the tensions at the end of 2013.
First, tensions could dissipate since the reinforced year-end effect has gone.

Just to recall, in the last few weeks of the year:

1.     The overnight rate (EONIA) has risen from 11 bp on 2nd of December to 45 bp at the end of the year,
2.     Euribor 3 months has risen in the same period from 24 bp to 29 bp,
3.     The 1 year OIS in one year time has risen over the same period from 19 bp to 29 bp,
4.     Excess liquidity in the €-area has increased from EUR 190 bn to EUR 275 bn (EUR 85 bn increase) between the 2nd and 30th of December, mostly as a consequence of the  underbidding at the operations offered by the ECB to sterilize the liquidity created by the Securities Market Program (SMP).

There is of course consistency between the quantity and the interest rate developments mentioned above. The prospective use of end of year balance sheets for the ECB Asset Quality Review made liquidity more valuable, because of a stronger than usual window dressing effect [€ liquidity is getting more valuable: what can be done about it?], thus raising the demand and therefore the supply of central bank liquidity (given that banks determine its amount outstanding through the prevailing full allotment auction). The increased supply could not completely offset, however, the interest rate effect of the increased demand and the offer to deposit excess liquidity at the ECB for 1 week with a remuneration of 25 basis points lost much of its appeal when money market rates approached that level.

Under this first scenario, money market rates should go down, underbidding at SMP sterilizing operations should be less common and excess liquidity should return towards the 150-190 level prevailing before the end of year effect would manifest itself. At the same time, the incentive of banks to return the liquidity borrowed under the 2 three year Long Term Refinancing Operations should decrease, as the perceived stigma effect of borrowing from the ECB should be weaker once the date relevant for the AQR has passed. More generally there may be less reluctance to borrow from the ECB, also on other types of operations. Therefore excess liquidity should remain consistent with the overnight rate, EONIA, staying somewhat closer to 0 than to the 25 bp of the official rate of the ECB (the Main Refinancing Operation – MRO rate).

Second, tensions could remain, albeit reduced, and the ECB could decide to promptly counter them considering them as inconsistent with its forward guidance and with its view that the €-area economy needs an accommodative policy, given the prevailing dim price prospects. I have dealt with the different tools that the ECB could use for this purpose in previous posts. You would know by now that top of my list are a new Very Long Term Refinancing Operation, to roll over the ones that are getting closer to maturity, and a stop of the operations to sterilize the liquidity effects of the SMP purchases [Is the price stability target of the ECB at risk?]

Third, interest rate tensions could remain but the ECB could decide not to do anything. The resulting situation could be quite unstable. High money market rates would push banks away from the SMP sterilization operations, the resulting increase in excess liquidity would have a subduing effect on interest rates and the participation to the sterilization operations would again be profitable, thus creating the potential of an instability cycle. The instability would be further aggravated from the fact that the behaviour of each bank in its borrowing from the central bank would depend on its expectation of what other banks would do: for an individual bank the best situation would be to do the opposite of what other banks do. If other banks inject liquidity into the system, by not participating in sterilization operations, and push down market rates, participating in these operations and getting the MRO rate at which the deposits are remunerated is profitable. Vice versa, if other banks do participate in sterilizing operations, market rates would go up and the choice not to participate becomes more interesting for the individual bank. Given the impossibility to have an objective, rational, expectation of what other banks will do and the instability intrinsic in deriving this expectation from the last episode of participation to the sterilization operations, the instability would not have an obvious way to be resolved.

I imagine the reader that followed me so far would like to know what is my guess about the probability of the three scenarios.

I give the highest probability to the first scenario of lessening of tensions, even if the risk of an “endogenous tightening” of monetary conditions as excess liquidity moves towards zero, which I presented in previous posts [€ liquidity is getting more valuable: what can be done about it? and Can the ECB control interest rates?] remains and may eventually push the ECB to find ways to inject more liquidity into the system.

I give the lowest probability to the third scenario that the ECB decides to do nothing and maintains this decision: either the ECB will see the potential of instability that I envisaged above and will want to avoid it or will observe for a while the actual instability and want to stop it by some intervention.

Of course, only an intermediate probability is left for the second scenario of continuing instability and prompt ECB action.

Only a few days will be needed to see how things will actually develop. The sharp fall of EONIA on the first working day of 2014 is consistent with the first scenario.


*** Research assistance was provided by Mădălina Norocea

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