There are early indications traders are gearing up for another period of bond scarcity in Europe that risks blunting the impact of monetary tightening.
(Bloomberg) — There are early indications traders are gearing up for another period of bond scarcity in Europe that risks blunting the impact of monetary tightening.
Concern is mounting the European Central Bank won’t extend a waiver on a 0% remuneration cap for government deposits that expires on April 30. That could drive some of the €390 billion of cash held by national Treasuries into higher-yielding money markets, where safe securities such as government bonds are used as collateral, pushing down rates.
Strategists at Societe Generale, Bank of America Corp. and Commerzbank AG say traders may already be preparing for that eventuality and hedging their risk. The premium investors are willing to pay for German two-year bonds over equivalent swaps increased in January for the first time in four months, bucking a broader trend in repo markets.
An extension of the waiver is “no longer being perceived as a foregone conclusion by the market,” Commerzbank strategists including Michael Leister wrote in a note to clients, who points to the divergence.
The 0% cap was initially introduced to encourage governments to place deposits on the market, and to assuage concerns around potential monetary financing. The restriction was temporarily removed in September to help the ECB ensure that its rate hikes filtered through the real economy in a time of collateral scarcity.
Since then, money market conditions improved, with German two-year asset-swap spread falling over 50 basis points from the peak in September. Some believe this should be enough for the ECB to stick to its plan to encourage governments to find alternative arrangements to central bank deposits while others, including JPMorgan Chase & Co, think officials will likely opt to avoid any risk of market disruption.
“Our discussions with investors in December and early January suggested that not many were preparing for the return to 0% remuneration by end of April,” Sphia Salim, head of European rates strategy at Bank of America wrote in a note, adding that recently those “views seemed to evolve.”
An ECB meeting on March 16 may bring clarity on the cap, but until then “the market should continue to price a risk premium in the swap spreads,” Societe Generale strategists including Adam Kurpiel wrote in a note to clients. They estimate markets are pricing in around a 33% chance of the ECB reinstating the cap.
The ECB hasn’t given any signs on whether it intends to prolong the waiver. After the cap was temporarily removed last year, Chief Economist Philip Lane said officials were “attentive” to the collateral scarcity concern.
Any signals that the cap will be reinstated as originally planned are likely to cause “strong” swap spread widening, according to Commerzbank.
–With assistance from James Hirai and Greg Ritchie.
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