EUR rates EONIA less than zero? Nordea Research, 16 June 2014

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1 EUR rates EONIA less than zero? Nordea Research, 16 June 2014 Negative EONIA fixing (and short swaps) are likely. Indeed, we re there now for the 1w swap Excess liquidity to increase as SMP sterilization terminated On the EONIA curve, risk/reward favours paying 6M6M whereas steepeners look best vs. Euribor based swaps. Lars Peter Lilleøre Chief Analyst IR products Global Strategy Alexander Wojt Analyst Strategy Research Sweden Executive summary Main conclusion. Negative EONIA fixings (and short swaps) are possible, and very likely in the immediate future. They are unlikely to stay below zero for long unless the ECB delivers more liquidity and cuts down the line, which we do not expect at this time... EONIA level and excess liquidity. The termination of the SMP sterilizations will likely push excess liquidity above EUR 200bn already this week, pushing EONIA closer to, and likely below zero... A look at the Danish experience. A look at the Danish case of negative deposit rates shows that the T/N fixing went below zero when the depo rate was cut to negative. Naturally, differences exist when comparing with the situation in the Euro zone but there are also some clear similarities... The dangers with low/negative EONIA. Low short-rates for too long could be an harmful environment for money market funds and unsecured lending volumes could suffer, increasing the fragmentation Market observations. Risk/reward on the EONIA curve favours paying e.g. 6M6M at below 2bps. The EURUSD xccy basis still has room for widening and the FRA/OIS curve looks too inverted. Fig 1. Flirting with the zero level Fig 2. Danish sub-zero experience Contents 1. EONIA and excess liquidity 2. The Danish case 3. The problems with low EONIA 4. Markets are digesting nordeamarkets.com/research

2 EONIA less than zero? 1. EONIA and excess liquidity Excess liquidity to increase significantly this week The relation between EONIA and excess liquidity provides a guideline how the overnight rate could react to liquidity easing. Starting with what is certain, this week the SMP sterilization will be terminated and excess liquidity could be boosted by close to EUR 110bn (though this may be counteracted by less use of the MROs/LTROs). That could increase excess liquidity to above EUR 200bn, a level that might translate into EONIA turning negative (Fig 3). However, disregarding the TLTRO effect, we could be back to the EUR 100bn level already this autumn (Fig 4). Fig 3. The relation between EONIA and exc. liq. The TLTRO is the big unknown in terms of liquidity Fig 4. Possible effect from SMP steril. termination The big unknown in terms of liquidity going forward is however the impact of the TLTRO. We have looked at two extreme scenarios. In the first, there is no TLTRO uptake and the 3y LTROs are repaid in spring next year (Fig 5). In the second, there is a 300bn take-up and the 3y LTROs are rolled in other operations when they mature. A scenario in the middle is probably the most likely, but a couple of aspects are worth highlighting. (i) There may be a significant interest in switching from LTROs to TLTROs (Fig 6). (ii) It s uncertain to what extent the stigma effect could reduce TLTRO uptake. (iii) LTRO repayments could pick-up before the new loans are offered. (iv) Is the carry trade attractive enough? (v) What will be done with the money? All in all, we don t expect the TLTROs to be changing the liquidity landscape drastically, but they may make sure excess liquidity remains above 100bn. Fig 5. Excess liquidity scenarios Fig 6. LTRO vs TLTRO volumes 2

3 Clear similarities between the Danish case and the one in the Euro zone Negative depo rate in Denmark meant negative T/N fixing 2. The zero level the Danish case While the negative deposit rate is new and unchartered territory for the ECB, other central banks have very recently been there. We find it useful to look at the very recent case from Denmark, which had a negative deposit rate from July 6 th 2012 to as recent as April 24 th this year. Obviously, there are fundamental differences between the situation and scope in Denmark and that in the Euro-zone right now. However, there are also clear similarities. First off, the motivation is partly the same: Weaken the currency. For the ECB, this will likely never be an explicit goal, but implicitly a weaker Euro serves them well, e.g. in the feed-in to inflation expectations. In Denmark, this was the explicit reason for a negative deposit rate to defend the Euro-peg. Also, many of the interesting questions that surround a negative deposit rate are identical 1. Can O/N fixings go negative (and transactions still occur)? 2. Can OIS based swaps go negative? 3. Will banks park money when charged? 4. Will the O/N market work? 5. Does other money market features matter e.g. excess liquidity? Perhaps surprisingly, the answer to all of these based on Danish happenings is yes. We think this also will be the case now in the Euro-zone, provided the conditions are there, though there s a decent chance that the potential period with negative EONIA rates will be temporary. In Denmark, T/N fixings went negative without a hitch (Fig 7). Further, while there is no official data available for the volume in neither the overnight transactions nor the Cita swap flow, our clear understanding is that the flow did not decrease, if anything it increased for a variety of reasons. This was aided on by the liquidity in the system at that time (Fig 8). Just as is the case now, loads of liquidity moves the T/N rate towards the opportunity cost of the deposit rate of the central bank (note that in Denmark the size of current account which paid zero interest at the time was increased at the time of the negative deposit rate). This is not mimicked by the ECB currently. In the OIS swap market flow came in large part because further cuts at that time weren t unrealistic. Naturally this is also the case now for the ECB if Fig 7. T/N fixing going negative in Denmark Fig 8. Liquidity in abundance 3

4 Danish banks did park funds at negative rates The lesson from Denmark is clear yes, EONIA fixings can go negative Low EONIA has historically meant low volumes say the TLTRO turns out to be a relative dud and more is needed, then short Eonia swaps at say -3bps might look high in a relative metric. The answer to whether banks park funds at a negative rate is yes, but clearly, alternatives will be sought out for liquidity. But these have to be present. In 2012, Danish govies had negative yields and apart from utilizing the folioaccount fully, alternatives were hard to find. The obvious transfer into EURassets was complicated because that s where the risk originated (this was prior to Draghi s whatever it takes ). The same is the case now, though there conceivably are more alternatives now for Euro-zone banks. For instance, those with a US banking license can convert EUR to USD and park them at the Fed instead. But in general, as risk aversion now is much less than 2012 levels, risky but liquid assets (or at least riskier) may be considered as alternatives. Overall, the lessons from Denmark tell us that yes - Eonia fixings can go negative as can Eonia based swaps. The deposit account will likely be used even facing the cost of 10bps. Alternatives will be sought (liquid assets or deposits elsewhere) and excess liquidity is central. We think that these alternatives are more viable now than was the case for Danish banks in 2012, and as liquidity likely will not be massively boosted through the TLTRO, the period of negative Eonia s will likely be temporary. Somewhat paradoxically, a small take-up on the TLTRO (in Q3 and Q4) could decrease EONIA s at that time as in that case alternatives (e.g. QE and additional cuts) will be priced in. 3. The problems with low/negative EONIA A negative deposit rate and low, even negative EONIA, doesn t necessarily come without problems. The EONIA volume is vaguely correlated with the level (Fig 9) and the recent rise is likely explained by the higher volatility during the past six months. This was promptly highlighted by Draghi in May: the amount of liquidity on the EONIA market has increased quite significantly, which is to some extent a positive sign / / In other words, banks rely less on the ECB and more on each other. Thus, lower unsecured volumes could possibly be interpreted as an increase in fragmentation, and that should be a concern for the ECB. Fig 9. EONIA level and volume move together Fig 10. The unsecured market on a down-trend 4

5 The volumes in the unsecured market are on a decreasing trend Turnover in the unsecured market has decreased quite rapidly during the past years (Fig 10) and the market beyond one week barely exists (Fig 11). This should make the environment for money market funds, an important sector for the functioning of the money market and thereby the transmission mechanism, less healthy. Looking at the development in the US after the zero interest rate policy was introduced, money market fund savings dropped by about a third and has not recovered since (Fig 12). When the ECB cut the deposit rate to zero in 2012, a number of the world s largest providers of money market funds restricted or even closed for new investments. Profitability would simply not be there with parts of the shortend at negative levels. The ECB s latest move will unlikely improve the situation. Fig 11. Unsecured lending beyond 1w is fading Fig 12. The problem with MM funds and low rates 4. Markets are digesting where to from here Steepening potential in the front-end It s no surprise that the ECB package has given way to new record lows on both the very front end, the 5Y swap and also on many implied volatilities in the vol market. At the same time, a profound flatness has occurred, especially in the front of the curves. For instance, the 1y1y vs. 1y spread against Euribor 3M fixings now lies in just 3bps; this means that risk/reward here is tilted towards steepening, in our opinion. Also, the trough on the EONIA curve, for instance 6M6M below 2bps, looks apt for paying. In six months, excess liquidity is likely to be lower again and the time also corresponds to the second take-up opportunity on the TLRTO. Unless Fig 13. Down collectively, but EONIA the fastest Fig 14. Term structures are now extremely flat 5

6 Dec 14 FRA/OIS looks too low something unforeseen happens, the ECB is unlikely to do anything drastic before that time, such as substantial additional cuts in the deposit rate or QE. In that light, we like paying 6M6M. We also think that the curve against Euribor fixings and that against overnight fixings looks a bit off relatively. Put differently, the FRA/OIS structure to us looks too inverted. In particular, the Dec-14 (IMM date 17- dec) looks too low, and has only moved marginally down since before the recent ECB meetings (Fig 15). Paying that area is attractive also given the fact that these spreads were not only temporarily sticky when Denmark went below zero. Fig 15. FRA/OIS: Recent dynamics Fig 16. EURUSD xccy basis more room still EURUSD xccy basis still has room to move lower Finally, the EURUSD xccy basis has moved quite a lot already, in the short end particularly, but we feel there is some room left for this movement. The correlation to the FX spot has been, and will be short term at least, very strongly correlated with this (Fig 16). That again comes from money market rates and could still conceivably entice some banks with license in both the Euro area and the US, to swap EUR for USD funds. We can easily see the 1Y EURUSD xccy basis near -15bps in the near future. Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgement of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets. 6