Surviving the liquidity squeeze

Excess liquidity in the euro funding markets halved at the beginning of July, causing Eonia to leap higher. The extent of the move surprised traders and caused problems for some participants. Christopher Whittall reports

The week leading up to the expiry of the European Central Bank’s (ECB) one-year long-term refinancing operation (LTRO) on July 1 was watched with interest by the media and traders alike. Hot on the heels of the sovereign debt crisis, many pundits assumed a large number of eurozone banks would rely heavily on ECB funding, and expected a substantial drawdown on the ECB’s three-month LTRO on June 30 to compensate for the one-year operation’s expiry.

For these onlookers, the events leading up to July 1 were largely a damp squib. Despite the expiry of €442 billion of funding from the one-year LTRO, the three-month tender on June 30 had a relatively subdued take-up of €131.9 billion – representing a €310 billion decline in the LTRO. Taken in conjunction with the central bank’s other open market operations, total excess liquidity declined by about €167.7 billion to approximately €150 billion, according to estimates from Société Générale. This was good news: eurozone banks were not as desperate for funding as some people had supposed.

“In general, the market is taking it quite positively. If €440 billion had been rolled at the ECB, it would have told everyone those assets couldn’t be funded elsewhere,” says Richard Armes, co-head of European interest rates at Morgan Stanley in London.

For short-term rates trading desks, however, the news was less positive. The sudden evaporation of excess liquidity caused the euro overnight index average (Eonia) to leap unexpectedly higher, in turn causing a number of challenges for dealers. Having fixed at 32.5 basis points on June 29 – well within the 30–35bp range it had occupied for much of the prior year – the overnight rate surged to 54.2bp on June 30. Eonia has been volatile ever since, falling back to 39bp before rising again to 55.6bp on July 16.

“I think a lot of players were expecting the banking community to rely on the ECB for funding a little bit more for the next few months, and were positioned for Eonia to stay low for quite a while. They obviously didn’t expect the Eonia fixings to head up so quickly, which was a bit of a surprise for the market generally,” says Jan Lundstrom, director for interest rate swaps at Barclays Capital in London.

The sharp reduction in excess liquidity and rise in Eonia have filtered through to other market dynamics: three-month Euribor rose from 76bp on June 29 to 88bp on July 22, while both the Eonia-Euribor and three-month versus six-month Euribor (3s/6s) basis have tightened.

Crucially, market participants predict Eonia will take its lead from the level of excess liquidity in the system for the foreseeable future: more excess liquidity and Eonia is likely to fall; less surplus liquidity and the overnight rate will rise. This means the Eonia fixing will no longer be as predictable as it has been, and traders will be glued to the results of the ECB’s seven-day tenders each Tuesday for clues. The longer-term refinancing operations in July, August and September will be awaited with even greater anticipation.

“When there was ample long-term liquidity, we were in an inelastic regime where Eonia was pretty much stable below 35bp. Now we’ve moved to an elastic Eonia regime, where the level of Eonia is a function of the total excess liquidity in the system,” says Vincent Chaigneau, global head of rates strategy at Société Générale in London.

The uncertainty in the market caused a noticeable spike around the beginning of the new ECB maintenance period on July 14. Some market participants feared there would be a substantial front-loading of reserves, which would drain surplus liquidity and push Eonia up further. Consequently, the one-month Eonia forward for the ECB reserves period running from July 14 to August 11 rose to 62bp after July 1, compared with around 40bp in the days leading up to it.

“Every Tuesday in the money markets feels like an ECB interest rate decision, as the whole liquidity profile of our markets has a big potential to change. On a week-to-week basis, we could get a fundamental move in Eonia. The euro money market was dead for the first two weeks of July because of the uncertainty surrounding where Eonia, the anchor point of the euro money-market curve, would set,” says Colin Bermingham, head of non-sterling liquidity management at Barclays Capital in London.

Intra-day volatility has also jumped, with the one-week Eonia forward trading in a 5–10bp daily range around the expiry of the one-year LTRO on July 1. Previously, intra-day volatility had typically been around 0.5bp.

“The intra-day volatility is unprecedented for the past couple of years. It has calmed down a bit now as excess liquidity has increased slightly, but the volatility around the beginning of July was incredible – it was off the scale. Also, people don’t like this intra-week volatility we’ve now got from the one-week main refinancing operation. We are going to look for a good take-up in forthcoming LTROs to see excess liquidity in the system get above €150 billion to settle things a bit,” says Perry Walsh, a director in short-term rates trading at Royal Bank of Scotland (RBS) in London.

However, the ECB has not scheduled any further LTROs beyond September, causing some jitters among market participants, who expect Eonia to rise further as a result. The Eonia forward for the November ECB governing council meeting rocketed to 77bp in mid-July.

Some participants think the forward rate has gone too far. Chaigneau at Société Générale estimates excess liquidity would have to dwindle to around €40 billion for Eonia to increase to that level – a scenario he believes is unlikely. “For Eonia to trade at 77bp in November would suggest almost a complete normalisation in Eonia rates, which we don’t believe will happen,” says Chaigneau.

Instead, this leap in forward rates is symptomatic of a degree of short covering and surprise in the market, say dealers. “I’m not sure the market was set up for this drain of excess liquidity – the market didn’t seem to believe the ECB would allow this to happen. So we’ve seen some short covering where people were paying to receive some term Eonia. This also had an impact on Eonia-Euribor basis, which started to narrow,” says Walsh. 

The Eonia-Euribor basis began to tighten from the start of July, reflecting the sudden upsurge in Eonia and more modest rise in Euribor. The spread between the two rates tightened from 30bp on July 12 to 24bp on July 19, as the Eonia fixing rose from 39bp to 56bp. This has presented some problems for dealers, as many hold Eonia-Euribor widening positions as insurance against a sudden shock to the market. The rationale is that it will become trickier for banks to fund themselves in a crisis, pushing three-month Euribor up. However, overnight liquidity is likely to increase as central banks flood the market with cash, exerting downward pressure on Eonia. This was certainly the case during the crisis, with the Eonia-Euribor basis widening from 3.5bp in July 2007 to 207bp in March 2008.

“I think a lot of people had been running Eonia-Euribor widening positions as a general safe hedge to have in their books, which was unlikely to hurt the desk but would make a lot of money if there was a disaster. That was probably one of the more populated positions, which caused such extreme volatility over the past couple of weeks as people have tried to get out of it. It’s certainly one example of a big position that has been hurt by Eonia going up,” says Armes at Morgan Stanley.

It is difficult to quantify the magnitude of any losses from the narrowing in the Eonia-Euribor basis, but dealers say it is unlikely to be significant. In fact, some argue the move may be positive for the banking sector overall.

“I’m reasonably convinced the industry as a whole benefits from lower Euribor rates relative to overnight funding, because it helps banks if they can fund themselves for a longer time period at lower levels. The spread between Eonia and Euribor is a detriment to them,” says Simon Wilson, deputy head of delta flow trading at RBS in London.

The 3s/6s basis has also been hit by recent events, with the spot basis tightening from around 19bp to 13bp after the expiry of the one-year LTRO. Many trading desks had been positioned for a widening of the 3s/6s basis last year, partly as a result of asset swap flows from mainly public-sector finance players, which wanted to receive three-month Euribor – a trade banks hedged by receiving six-month Euribor. That exposure turned out to be extremely profitable following a sharp widening in the basis in 2009 (Risk December 2009, pages 28–30). Many dealers say they have reduced their widening positions since, but it is likely some mark-to-market losses were sustained. Similarly, some hedge funds – which tend to run shorter-dated 3s/6s positions compared with market-making desks – had put on forward-starting 3s/6s widening positions as a tail risk hedge. They would have felt the pain as the one-year 3s/6s basis one-year forward tightened from around 20bp before the one-year LTRO expired to 15bp after July 1. 

“Some players had the 3s/6s basis on because it had positive carry, but as the value of the spot six-month fixing compressed sharply, it quickly became a negative carry trade. I also think market participants had put speculative positions on, as the 3s/6s basis seemed like an obvious trade to hedge against increased risk aversion towards the European banking sector. But with the extreme volatility over the past month, the position just became a little overcrowded,” says Shane O’Cuinn, head of European swaps trading at Credit Suisse in London.

The future path of the 3s/6s basis remains uncertain. However, with corporate bond issuance expected to increase in the coming months, many expect the 3s/6s basis to widen back to pre-July 1 levels. Lots of issuers decide to swap their fixed liabilities into three-month floating, with dealers hedging this by receiving fixed against paying floating rate at six months – a tightening position. The resulting demand to offset this exposure could force 3s/6s basis out wider, say dealers.

“There is still room for the 3s/6s basis to widen because the euro forward basis is still a lot tighter than the implied spot basis. I think we’ll also see more liability swaps against three-month Euribor, which will push the forward basis out further. So basis widening positions still make sense, but I also think people have taken some of that risk off the table because it’s not the home-run trade it was a year or two ago,” says Lundstrom at Barclays Capital.

An increased focus on longer-term funding by banks could also help push the 3s/6s basis wider, say bankers. New capital and liquidity rules drawn up by the Basel Committee will require banks to eliminate mismatches between assets and liabilities – meaning they will not be able to rely so much on overnight money and will need to raise more term funding, increasing the cost of longer-term money.

“Banks may be under pressure to do more term funding as their liquidity situation is examined by regulators. That would suggest some more upward pressure on the 3s/6s basis, as people pay more for longer-term funding or put on hedges in anticipation of the need to fund more term in the future rather than funding overnight,” says Garry Monaghan, head of euro swaps and bonds trading at BNP Paribas in London.

Despite this, the short-end of the rates curve will remain the primary focus for traders in the coming weeks. The ECB has scheduled three more full-allocation three-month LTROs on July 28, August 25 and September 28, while its final seven-day main refinancing operation is currently due to take place on October 5.

However, some speculate the ECB will extend its market operations further. In particular, analysts draw attention to the central bank’s final three-month LTRO expiring on December 23, 2010. Many believe it would be unhelpful for the ECB to curtail its liquidity operations one week before year-end due to the heightened event risk this would create. As a result, a consensus has emerged that the ECB will extend its full allocation open market operations into 2011 to prevent market jitters at the turn of the year.

“In light of the recent squeeze in the short-dated Eonia and the three-month Euribor fixings, I think the ECB could well be considering further liquidity operations, especially an operation that would take it over the year-end. If we are approaching the New Year and this volatility hasn’t subsided, it could be pretty difficult for banks to get adequate funding over year-end, which would not be healthy,” says Walsh at RBS.