Europe's central bank is missing the mark in money markets
The ECB has, despite an early gaffe, decided that it is its job to close spreads after all — and for the most part, it is excelling in its task. But its attention is focused on the bond market and, as a result, those who rely on the money markets for short term funding are suffering.
The spread to Bunds on sovereign bonds from the eurozone periphery, though still wider than many would like, are undoubtedly far narrower than they would be without the intervention of the ECB and its mighty Pandemic Emergency Purchase Programme. But the three month Euribor-OIS spread is at its highest level since 2012.
This is not like the 2008 crisis. We’re not facing a financial crisis (yet) and as a result, analysts say that the move is not driven by increasing counterparty risk as it was then, but by a lack of liquidity. That much is clear from the fact that, while Euribor and OIS gap out, bank CDS spreads remain stable.
The money markets are an important resource for borrowers across asset classes, and many of them are having to make increased use of it to fill in for revenue shortfalls and increased expenditure. This is a particularly difficult job when many of the usual funds are holding back, meeting waves of withdrawals as end investors look to bury their cash under the mattress.
The US Federal Reserve has done a much more thorough job in protecting the dollar money markets, which is just as well, since they are an order of magnitude larger than the European equivalents. Its money market fund liquidity facility provides loans to financial institutions secured by high quality assets purchased from money market funds, thus providing cheap loans to banks and helping funds manage redemptions without withdrawing from the market.
While the ECB has not followed the Fed’s methods, it obviously realises the importance of the instrument, or it would not have started to purchase corporate commercial paper.
But its efforts have not been well calculated to relieve the stress — largely, it would seem, due to a misunderstanding of the market.
Agency borrowers, who are finding their access to much needed short term cash strained and expensive at a time when they need it most, have received precious little relief from the ECB, which only buys CP with a tenor longer than 70 days.
Most CP investors are clustering at the very short end of the curve to preserve liquidity, meaning agencies find little primary market demand for such long dated CP.
And as agencies scramble for what cash they can get, they crowd out bank issuers, forcing them to borrow money in the interbank market, pushing up Euribor.
The ECB buys corporate CP directly and the sector ultimately benefits from central bank lending. But that only helps the large, blue chip corporations that have and regularly use CP programmes.
If the central bank wants to ensure corporates have continued access to short term cash, a more efficient way of doing this would be to lift its restriction on purchasing bank CP. Easing liquidity concerns at the short end of the curve for banks would allow them to continue to offer cheap short-dated funding to corporate clients.
But instead of abandoning its long held aversion to buying bank assets, the ECB may simply push Euribor down by cutting rates.
The ECB has done a superb job in ensuring that borrowers have access to bond markets at reasonable prices, but its intervention in the short term markets appears to have been an attempt simply to apply the same rules that worked in bond markets. It would do better to follow the Fed.