(Bloomberg) — Short-term German debt was in high demand Monday after the nation’s central bank said it would stop paying interest on domestic government deposits, a move that could spur billions of euros into the market.
(Bloomberg) — Short-term German debt was in high demand Monday after the nation’s central bank said it would stop paying interest on domestic government deposits, a move that could spur billions of euros into the market.
While officials had signaled that the 0% rate would eventually return, the sudden nature of the Bundesbank’s new policy announced late Friday caught the market off-guard. It also threatens to revive concerns over market dislocations as the cash gets deployed, out of the central bank’s accounts, and into bills and other short-term securities.
At €54 billion ($59 billion), general government deposits held at the Bundesbank at the end of July are around a fifth of their all-time high. Still, traders are concerned a quick shift could exacerbate the scarcity of high-quality collateral in the region. A surge of cash chasing high-quality securities would also lower yields and hinder the transmission of rate increases into markets.
“The Bundesbank is taking no prisoners,” said Commerzbank analysts including Michael Leister. The move to 0% is “a big surprise — and will also be an experiment with unknown outcome for the Bundesbank and the Eurosystem,” they said.
The decision was all the more notable because it breaks from the European Central Bank’s own policy of only gradually weaning government depositors off higher interest rates.
Read more: Return of ECB 0% Deposit Cap Would Shake Money Market, BofA Says
The rate on German two-year notes fell as much as six basis points to 2.95% after the Bundesbank said late Friday it will remunerate domestic government deposits at 0% starting Oct. 1. That compares with the current ECB cap of 20 basis points below the euro short-term rate, which puts it around 3.45%.
The two-year notes later pared the move but still outperformed comparable interest-rate swaps, a sign heightened demand was moving the market, rather than any shift to the outlook for monetary policy. Demand for nine-month German bills at an auction jumped to the highest since February 2022, with the policy shift also filtering through primary markets.
Gradual Withdrawal
The ECB and its central banks have historically refrained from paying interest on most government deposits in order to encourage investments in the open market. But in recent years, an excess of cash relative to suitably-safe bonds has created distortions in money markets, and a return to the 0% cap may exacerbate that.
In September, Europe’s governments rushed to lower their cash holdings held at the central bank on the expectation interest would be capped at 0% even as the ECB raised its deposit rate above that level. The ECB ended up temporarily removing the 0% ceiling to avoid a sudden exodus into higher-yielding money markets.
Since May, the central bank started remunerating government deposits at a less attractive rate to encourage a gradual withdrawal of funds. At the time, the ECB said “it stands ready to make further adjustments to the remuneration regime if necessary.”
“You could argue the larger adjustment is already behind us,” said Benjamin Schroeder, a strategist at ING. “Perhaps this is why the Bundesbank thinks/hopes the impact on collateral scarcity won’t be as significant.”
In an April paper, the Bundesbank said it would “make sense” to reinstate the 0% cap “further down the line” given that “these deposits do not fulfill a monetary policy function.”
Scarcity Speculation
Some analysts say other national central banks may follow suit by announcing similar measures. Meanwhile, the ECB could issue a statement reiterating its current position remains unchanged, according to Barclays.
“Buba’s decision to carve its own path by slashing interest to 0% on public deposits rather than undertaking a gradual adjustment should be a learning process for the bank and the Eurosystem as a whole,” said Barclays analyst Rohan Khanna.
Analysts at Commerzbank predict German bills will outperform following Friday’s adjustment.
“Another BuBill run cannot be excluded and scarcity speculation looks set to intensify further in coming months,” said Leister’s team. That said, the German debt agency “should continue to provide sufficient collateral to the market and stand ready to counter disruptive scarcity if needed.”
–With assistance from Jana Randow.
(Updates with quote, details throughout.)
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