Sean Keanes Whats happening in the Money Markets

02 December 2011

EUR FX Swap premium remains elevated as Draghi notes collateral difficulties

Summary (click on link to jump to specific section):

Draghi hints and the market waits 2012 euro-zone funding hurdle still a monstrous 7.5bn per day EUR FX Swap premium remains elevated as Draghi notes collateral difficulties Two Fed Governors say no a discount rate cut, despite its premium to offshore funding rate USD 3 month LIBOR finally falls, after 91 successive increases USD FRA/OIS spreads at midday in Asia

Draghi hints and the market waits Mario Draghi did enough yesterday to maintain the mood of cautious optimism in the euro-zone markets, hinting and suggesting that more can be done, though clearly there is still some political position shuffling that needs to take place to get everyone comfortable. The market appears to be favouring the idea that Draghi is about to go to the dugout and take out the big bat after having watched a succession of strike outs in the lead up to this point. The fielders have moved back in a precautionary fashion, having previously been tight around the bases. Their fear is that the new ECB President will now hit the ball over their heads and clean out of the park with further significant announcements coming next week. If Draghi does come up with some game changing announcements then the capacity for further relief rallies into year-end is clearly significant. Uncommitted monies will be forced from the sidelines, equities will rally strongly into year end, and all manner of bearish trades will be forced into the open and put to the market sword. December is a time of year when p/l surprises are least welcome. Year end assessments have already been made, and the meagre payouts on bank books have been calculated. Any upsets to the profit projection at this late time are viewed very negatively, and traders will be encouraged to exit rather than add to risk. Draghi has the market (slightly) on the back foot for the first time in many months. The calendar is offering him the opportunity to press home this advantage, and drive a year- end rally in peripheral bonds, and European equities. Failure to capitalise on this timing advantage will be a squandered opportunity given the significant refunding that are coming up in 2012. 2012 euro-zone funding hurdle still a monstrous 7.5bn per day Bloomberg ran a good article reminding us that even though the ECB have been given a breathing space by the lowering of USD borrowing costs, the term financing problems facing the continents sovereigns and commercial banks remain formidable. As we said yesterday, the USD funding issue is a symptom and not the cause of this euro-zone crisis, and the cause is a malignancy that will take more than a 50bp reduction in short term funding costs to fix. Bloomberg note that 2012 will see euro-zone sovereigns directly competing with the continents commercial banks for funding, as both groups seek to refund a total of approximately $2trn in maturing debt next year. Euro-zone governments are estimated to need refunding of approximately 1.1trn in maturing bonds, with Italy alone having to refinance 113bn in Q1 alone. Alongside this Europe's commercial banks have approximately 500bn in refinancing coming due

in the first half of the year, and another 275bn to fund in the second half simply to replace maturing debt. Without any shrinking in the asset (or cost) side of the balance sheet, its reasonable to assume that these number will be the minimum required. The banks need to play catch up on the term debt that they have not issued over the past 6 months, and they also need to issue more for Basel 3 compliance, assuming the EU regulators do not offer them some relief in this area. The sovereigns meanwhile may need to issue more simply to keep up with their rising debt burden. Not all of the economic pain can be absorbed by fiscal cuts and tax hikes. Moodys are quoted in the article as saying that euro-zone banks need to refinance at an average 1 rate of $230bn every three months in 2012. This compares with a $132 billion average for the 11 quarters ended Sept. 30 2011. These numbers will clearly place tremendous pressures on the markets with investors effectively being asked to come up with around 7.5bn of financing each and every business day of the year in order to reach the 2trn number. This volume of issuance would suggest that pricing power will remain with the investor rather than the issuer, and the interest rate premiums that will need to be paid will remain substantial regardless of what President Draghi comes up with. This overhang of upcoming debt issuance will continue to act as a restraining factor on the euro-zone bond markets, and also on the eurozone commercial banks. One way to provide some direct offset to this funding pressure is to shrink the balance sheets rather than seek to fund them. There have been numerous political comments suggesting that this is not an acceptable action by the banks, with such actions likely to reduce the flow of credit to the domestic economies of the banks involved. SME financing in particular is likely to suffer in such an environment. To counter this domestic political pressure the euro-zone banks will be forced to continue offloading offshore assets, many of which are denominated in USD. The French banks have clearly taken significant steps on this path already, with both BNP and SocGen announcing they had undertaken large USD asset sales during their Q3 profit results a few weeks ago. As each of these sales takes place the pressure on the EURUSD basis swap will diminish, and eventually the exposure will fall to a more self-sustaining level. In the meantime the imbalance remains and the selling of USD assets by euro-zone commercial banks will likely continue despite the reduction in borrowing costs. EUR FX Swap premium remains elevated as Draghi notes collateral difficulties The premium for borrowing 3 month USD via the EURUSD FX Swap dropped further over the past 24 hours, and now stands at LIBOR+120bp. This is down around 50bp from the highs seen earlier in the week, but is still obviously trading at an elevated level. One of the reasons that have been suggested for this ongoing pricing premium (banks can now raise from the ECB for 3 months at approximately 73bp, versus 170bp in the FX swap market), is because of a lack of eligible collateral amongst the most stressed borrowers. Euro-zone banks can only access the ECB funding rate if they present eligible collateral to the ECB in exchange for USD funding. It was interesting therefore to hear ECB President Draghi refer to this very issue yesterday in his speech to the European Parliament: We are aware of the continuing difficulties for banks due to the stress on sovereign bonds, the tightness of funding markets and scarcity of eligible collateral in some financial 2 segments. These comments are identical to the ones he made a couple of weeks ago at the European 3 Banking Congress , and they indicate that the ECB are themselves seeing evidence of the collateral shortages that we have previously speculated were occurring. Given the huge volumes of weekly MRO financing that is taking place it is clearly not the case that there is a system-wide

shortage of collateral. There issue again comes back to the fact that the market is bifurcated between the have-lots and the have-nots, and the have-nots are the ones with the most urgent USD financing problem. The FT has written a very good short piece on this subject, citing a paper from an IMF economist on the importance of the dealer community in transferring collateral through the system. The paper talks about the velocity of collateral in the same way that economists talk about the velocity of money. It points out that a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the primary source collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter chainsfrom constraining the collateral moves, and higher cost of capital 4 resulting from decrease in global financial lubrication. Aside from clearly pointing out that a breakdown in collateral transfers impedes the essential workings of the financial system the paper also calls upon global regulators to augment their monetary transmission data sets with information about the collateral markets, noting that There are links between pledged collateral that is intermediated by large banks and quantitative monetary policy instruments. President Draghi may well agree as the breakdown in the collateral transfer appears to be hindering a normalisation of the EURUSD basis swap rate, and may require further action from the ECB. One thing that we suggested yesterday is that the ECB could potentially undertake direct FX Swaps to get USD funding to those that most need it. This would be unusual for the ECB to do, though not outside its operating guidelines. The ECBs operational guidelines make clear that the Bank can undertake Foreign Exchange Swaps for monetary policy purposes. The document on The Implementation of Monetary Policy in the euro Area notes that They are used for finetuning purposes, mainly with the aim of managing the liquidity situation in the market and steering 5 interest rates The guidelines also note that such swaps are normally executed in a decentralised manner by the National Central Banks, though they note that the Governing Council of the ECB can decide that, under exceptional circumstances, bilateral foreign exchange swaps may be executed by the ECB. Given the ongoing dislocation in the markets, and the fact that the ECB President himself acknowledges that there are collateral problems, intervening in the FX Swap market would appear to be an entirely reasonable thing to do. It would also be dramatically effective at getting the USD funding to the precise counterparts that most need it. Two Fed Governors say no a discount rate cut, despite its premium to offshore funding rate We suggested yesterday that following the reduction of the USD borrowing costs for offshore central banks it may be the case that the Fed looks to lower the Discount Rate in the near future. The optics of having the emergency lending rate for domestic borrowers at 0.75% whilst the rate available to offshore institutions is around 0.60% is likely to draw some criticism from the US politicians. It was interesting therefore to see not one, but two of the regional Federal Reserve Bank 6 Presidents reject that notion yesterday during interviews with the WSJ . Both Dallas Fed President Richard Fisher and St. Louis Fed President James Bullard indicated that they saw no immediate need to take such action, with Bullard saying that demand for funds at the discount window had been low, evidencing no need for a reduction in the rate.

It will be interesting to see whether Bernanke and Dudley push for a change given that they are the ones who will be more politically exposed when the USD borrowing lines come up for discussion during the Chairmans next Congressional testimony. USD 3 month LIBOR finally falls, after 91 successive increases Short dated USD cash markets again traded a little better in New York yesterday, with local dealers reporting further lending activity taking place after a long drought. Interestingly the flow of funds that appeared to be taking place was from some of the smaller lenders, with little signs of a wall of money hitting the street from the US Money Market Funds as yet. The funds will want to see better secondary market liquidity in the paper of euro-zone issuers before they again commit significant funds to those names. Borrowers still want funding for 90 days and beyond, but the lenders that are in the markets only want the credit risk for a maximum of 90 days. At this stage the best that many borrowers can hope for is simply to get themselves fully funded over the calendar year end, and hope that money market conditions have eased by the time they return to the markets in 2012. One very welcome development for borrowers yesterday was that after 91 consecutive up-moves in the fixing rate, the 3 month USD LIBOR finally set a little lower, falling by 0.00167 of a basis point. Its not a lot of change for a 50bp reduction in the offshore borrowing cost, but those who are short funding will be relieved that the upward move has been at least temporarily interrupted. The forecast today is for the rate to again move a touch lower, though its quite possible that it could remain unchanged. The longer dated FRA/OIS spreads have actually pushed a little wider over the past 24 hours, signalling that the market sees the expected 3 month LIBOR rate in the mid to high 60s in the second half of next year, versus its current level around 0.525%. This forward premium has been a gravitational force pulling the spot LIBOR rate higher in recent months. Despite the reduction in offshore USD borrowing costs the 3 month USD LIBOR rate should still continue to push higher to meet the forwards. Any relief that has been engendered by the reduction in Fed lending costs to the ECB will have more of an impact on the FX Swap market than it will on the LIBOR fixing, which is still struggling to catch up with the forwards. As we wrote yesterday, LIBOR is an unsecured lending rate which means that the lender of cash will necessarily charge a premium for lending unsecured funds due to the additional credit risk involved. If the secured repo rate from the ECB is effectively 0.73% (allowing for initial margin and haircuts) then LIBOR should logically be higher. USD FRA/OIS spreads at midday in Asia attached courtesy of the Credit Suisse STIRT desk in Singapore. FRA 0*3 1*4 2*5 3*6 4*7 5*8 6*9 7*10 8*11 9*12 OIS 0.525 0.526 0.562 0.591 0.614 0.630 0.643 0.654 0.663 0.672 Spread 0.100 42.5 0.113 41.3 0.123 43.9 0.130 46.2 0.132 48.2 0.132 49.8 0.130 51.2 0.128 52.6 0.125 53.9 0.123 54.9

IMM FRA/OIS Spreads 21-Dec-11 21-Mar-12 21-Mar-12 20-Jun-12 20-Jun-12 19-Sep-12 19-Sep-12 19-Dec-12 19-Dec-12 20-Mar-13 20-Mar-13 19-Jun-13 19-Jun-13 18-Sep-13 18-Sep-13 18-Dec-13

42.8 47.3 51.9 55.3 56.3 54.4 53.1 54.4

References:

1. 2. 3. 4.

{NSN LVJA6V6S972L <go>} http://www.ecb.int/press/key/date/2011/html/sp111201.en.html http://www.bis.org/review/r111121d.pdf http://ftalphaville.ft.com/blog/2011/12/01/775341/draghi-we-are-aware-of-the-scarcity-ofeligible-collateral/ 5. http://www.ecb.int/pub/pdf/other/gendoc2011en.pdf 6. http://blogs.wsj.com/economics/2011/12/01/fed-official-dont-see-central-bank-cuttingdiscount-rate/

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