Draghi Grapples With Money Markets Showing Revival Too Soon

Mario Draghi may need to take action to stop money-market investors getting ahead of themselves.

For the first time since 2008, overnight interbank rates are starting to exceed the European Central Bank’s benchmark interest rate, signaling a return to pre-crisis behavior even as the economy remains fragile. That’s testing the ECB president’s promise that officials are ready to respond to any unwarranted monetary tightening.

While rising market rates could be a sign of normalization against the backdrop of a healing euro-area economy, the risk is that they increase loan costs for companies and households too fast and endanger that recovery. Draghi may steer against exuberance as soon as this week by deploying policies considered since last year, such as ending the absorption of cash from crisis-era bond purchases, according to banks including Societe Generale SA. “The ECB believes only in a very gradual recovery,” said Anatoli Annenkov, senior European economist at Societe Generale in London. “From that perspective, they’d probably be happy to push money-market rates as low as possible.” The ECB failed for a fourth week to sterilize the liquidity created under the Securities Markets Program today, signaling a preference by banks to hold on to funds in a tightening market. The average cost of overnight, unsecured lending between banks in the euro area was 0.254 percent last month, three times as high as a year earlier. The measure, known as Eonia, spiked to 0.457 percent on April 29, the highest excluding month-end volatility since 2011. The ECB’s main refinancing rate has been at a record-low 0.25 percent since November.

In normal times, when the ECB rations the funds it lends to the system, Eonia hovers just above the benchmark rate as lenders unwilling to pledge collateral for central-bank cash access the financial markets for a small premium. That relationship broke down in October 2008, a month after the collapse of Lehman Brothers Holdings Inc., when the ECB responded to the ensuing cash crunch by offering unlimited funding against eligible collateral. The cost of 3-month funds, which are more representative of borrowing for the real economy, is also showing a revival. Euribor is about 10 basis points above the ECB’s benchmark rate, the biggest spread since before the central bank injected about 1 trillion euros ($1.4 trillion) into the financial system at the end of 2011 via 3-year loans to banks. The trend could simply be a sign that banks are becoming less reliant on the ECB as the economy rebuilds, according to HSBC Holdings Plc.

Excess liquidity in the euro-area financial system, or the cash above that needed for normal functioning, has fallen as banks make early repayments of the 3-year loans. The indicator has dropped from more than 800 billion euros in March 2012 to as low as 80 billion euros on April 29. It rebounded to 177 billion euros yesterday. “There’s volatility in the system, but it’s not 100 percent clear what the reasons for it are,” said Annalisa Piazza, a fixed-income strategist at Newedge Group in London. “If this volatility continues for three or four weeks then the ECB could send the signal it’s more structural and do something.” Tighter and more-volatile markets increase the risk of what Draghi has described as a “liquidity accident.” The 30-day historical volatility for Eonia is the highest since at least 2004, an added concern for banks already dealing with a yearlong health-check before the Frankfurt-based ECB takes over supervision duties in November. Policy makers meet in Brussels on May 8 to set monetary policy amid mixed economic signals and an inflation rate that’s still less than half their goal.

The Organization for Economic Cooperation and Development said today that “a further interest rate reduction is merited, given the low inflation developments.” It cut its global growth forecast for this year to 3.4 percent from 3.6 percent in its November report, and predicted gross domestic product in the euro area will expand 1.2 percent in 2014, up from 1 percent in its November outlook. In a speech in Amsterdam on April 24, Draghi said any “undue tightening” in the monetary stance could be met with measures including an extension of the policy of granting banks unlimited cash or offering new long-term loans.

Executive Board member Benoit Coeure, who is responsible for market operations, has said the policy of meeting banks’ cash demands in weekly auctions is the most-powerful tool to manage the functioning of the market. The 7-day tender settled on April 30 added more than 50 billion euros to liquidity after the spike in rates the previous day. Eonia dropped to 0.126 percent by yesterday. The ECB allotted 129.1 billion euros in its 7-day tender today, down from 172.6 the previous week due to the decline in market rates in recent days.

The central bank just missed absorbing its intended amount in the weekly drain of liquidity added by the SMP purchases, attracting bids for 165.5 billion euros against a target of 167.5 billion. Halting the operation would add about that amount of liquidity, reflecting the value of outstanding bonds. Policy makers have so far declined to take that step, with Draghi telling reporters in February that the effects would be “relatively limited.” That provides an argument for other options such as tweaking the marginal lending facility. Cutting the penalty lending rate, currently at 0.75 percent, would lower the effective ceiling for money markets and help rein in the volatility, according to Benjamin Schroeder, a rates strategist at Commerzbank AG in Frankfurt who says excess liquidity should be high enough to provide banks with an adequate buffer. “The ECB would need to target a daily level of a little above 100 billion euros to keep Eonia steady just below the refinancing rate,” Schroeder said. “The ECB should also increasingly mull over liquidity interventions, such as stopping the SMP tender.”

While the ECB could yet take unprecedented steps such as charging banks to deposit cash overnight, economists view that as unlikely this month. Just two of 53 respondents in a Bloomberg News survey predicted the deposit rate, which has been at zero since July 2012, will be cut. Two out of 58 economists forecast a reduction in the key rate. “In the past few weeks, we have seen increasing volatility in money markets,” said Christian Reicherter, an analyst at DZ Bank AG in Frankfurt. “Now the ECB needs to decide if they want normalization, or if they have to do something.”