The Iran conflict and rising energy prices have shaken the ECB’s rate expectations, causing uncertainty in the market and a shift to safer assets. Money and funding markets show limited stress, but as aggregate activity tends to focus more on very short dates, particularly long EUR-bor spreads, more volatility is seen.
The rise in oil prices pushed the ECB out of its ‘good spot’
The biggest impact on the yield curve has come from the Iran conflict and rising energy prices, as fears of a 2022 rerun have gripped the market. The rate cut bias has turned into expectations of three European Central Bank (ECB) rate hikes by the end of the year. While a ceasefire has calmed the situation, the ECB signaled its readiness to act on any sign of second-round effects taking hold, keeping the possibility of a first rate hike as early as April.
We think the additional information the ECB will have at this point will be limited, arguing for at least a wait until June. If we follow our base case scenario, we think the ECB will continue to signal caution, but will eventually manage to keep rates steady. But we also have to recognize that at this stage, ECB policymaking is more about managing expectations. Currently, the picture presented by long-term inflation conversions is relatively benign. But that could still change as the crisis develops.
Uncertainty leaves its mark on currency markets, but there are no signs of stress.
The overall uncertainty and risk aversion in the market has also left its mark on the currency market. We’ve seen the 2-year-old German Schatz start to outperform conversions as the controversy deepens. This is a classic sign of flight to quality, although there was also a directional component to this last month.
Shorter maturities have shifted amid uncertainty surrounding the crisis and the ECB’s policy response. Signs of real stress in currency markets and the functioning of funding markets, however, remain limited.
In the repo markets, overnight GC polling rates had returned to the ECB deposit facility rate for the latter part of March, having previously sat 1-2bp above. However, the end of the quarter itself appeared to be driven more by liquidity demand this time around, as rates did not show the usual downward spiral that we saw last month and at the end of the quarter. German government GC is now back at quarter-end with the depo rate essentially flat, after earlier falling slightly. The Italian GC briefly moved 5bp above the depo rate in early March and again in early April, but for the most part it sat around 2bp, the lower end of the range just before the dispute.
European banks’ weekly CP/CD issuance volumes moved short-term.
Source: CMD, ING
In unsecured markets, we have also observed that for commercial paper, volumes from banks moved mainly in the 1m and below period, reflecting a shift in investor appetite.
Before the end of the quarter, the 1m Euribor-fixing ESTR fell even more significantly than the OIS, reflecting a reduced willingness to take on funding that does not add to meeting regulatory ratios but only expands the balance sheet.
There was a narrowing of the 3m Euribor OIS spot spread, but this was related to the technicalities of fixing and its fallback calculations rather than changes in credit perceptions. The spike quickly reversed, and the spot spread even reached its lowest print since late 2024.
However, volatility in OIS spreads has been most impressive over the longer term, where the 12m Euribor OIS spread has ranged from 10bp to 45bp since the start of the dispute. Earlier, the spread had been hovering in the 30bp to 35bp range since last September.
Far from spot-fixing, FRA/OIS expands briefly as a reaction to spread effects, but it also accounts for a good portion of that broadening. They remain slightly wider in terms of approximately one basis point, but it should be noted that the FRA/OIS band has previously shown a tendency to widen very gradually. This reflects the underlying ECB rundown of its balance sheet and the resulting reduction in excess reserves in the banking system.
EURIBOR tends to fluctuate over the long term.
Source: Refinitiv, ING
To recap, Euribor fixing represents the rate at which banks can borrow in an unsecured money market. To ensure ‘robustness’ and ‘representativeness’, the calculation of fixing is grounded as far as possible in actual transaction data.
For this purpose, a hybrid methodology using waterfall structure has been developed. At the first level, the actual transaction is used to calculate the fixing. If the contributing bank does not have enough transactions to support this Level 1 calculation, it may resort to a Level 2 calculation that uses anything from incrementally adjusted tenors to the use of private day contributions with market adjustment factors.
Errors, especially in more volatile times, become apparent when looking at the transparent data that the benchmark administrator provides periodically. In February, for example, a transaction volume of more than €130bn affected 1 week of fixing. But in the 1m to 12m period, volumes were only €5bn to €10bn this month. This meant that for 1-week, level 1 calculations were used 65% of the time, while 3m fixings saw level type calculations using earlier dates in 70% of cases.
ECB liquidity resource sees no fundamental change amid geopolitical turmoil
Banks’ actual recourse to ECB liquidity operations rose briefly to a still modest €17bn, but that had more to do with the end of the quarter than anything else, and volumes later returned to the €11bn region we’ve become accustomed to.
If the outcome of the war in the Middle East worsens, there is also a scenario where the ECB may have to reconsider its current balance sheet reduction on autopilot. For example, a stronger policy response in key rates could negatively impact European government bond spreads. In light of the uneven delivery of monetary policy, this may at least be an option to stop the quantitative tightening process.
For now, bond spreads have been relatively well-behaved. And while we’ve seen some widening on the back of rising volatility, overall levels aren’t far off from where they ended last year. Italy has been the hardest hit so far, but even the spread on bunds is currently slightly above the 10bp level since last December following more upbeat news from the Middle East.
In a recent blog post looking at how banks have adjusted to the gradual decline in excess reserves, the ECB concluded that money markets are operating smoothly and liquidity has been efficiently redistributed even as a large proportion of banks are operating close to required reserve levels. As this share is set to grow further, there will be upward pressure on funding rates as well. Eventually, this will also lead to a structural increase in support from ECB liquidity operations, but for now, market funding is cheaper than going to most central banks.
Market funding is still cheaper than the ECB.
Source: Refinitiv, ING
Disclaimer: This publication has been prepared by ING for purely informational purposes, regardless of the means, financial situation or investment objectives of a particular customer. The information is not an investment recommendation, nor is it investment, legal or tax advice or an offer or solicitation to buy or sell any financial instrument. Read more