Europe Passes The Inflection Point (Or Why LTRO3 Is Inevitable)
One year on from the "whatever it takes" speech and all appearances suggest Draghi's all-in move with the imaginary OMT 'worked. European sovereign spreads have compressed dramatically, European stock indices are near their highs, European financials are doing great. Of course, record unemployment rates, record loan delinquencies, record drops in house prices, and record deposit outflows can all be ignored because no matter what, Draghi will do "whatever it takes." Except, as JPMorgan notes, the excess cash in the Euro area banking system continues to decline reaching EUR230bn, closer to the so-called inflection point at which money market rates, i.e. EONIA and repo rates, are responding more pronouncedly to changes in the excess cash. Bank funding is becoming increasingly volatile since the 2nd LTRO repayment and the trend shows no sign of abating. We suggest Mrs. Merkel will be on the phone telling Mr. Draghi to "get back to work," - at least until September 23rd anyway.
Approaching the inflection point in Euro area money markets
The excess cash in the Euro area banking system continues to decline reaching €230bn, closer to the so called inflection point at which money market rates, i.e. EONIA and repo rates, are responding more pronouncedly to changes in the excess cash.
How have EONIA and repo rates behaved so far? Figure 3 shows the evolution of EONIA and Eurex repo market rates. EONIA reflects the rate at which banks lend to each overnight on unsecured basis. The Eurex repo market rate represents an effective interest rate in the secured interbank money market, computed as a volume-weighted average rate of all EUR overnight transactions in the ECB basket of the Eurex Repo GC Pooling market.
What Figure 3 shows is that since the second LTRO repayment at the end of February repo rates have started rising and becoming more volatile. In contrast EONIA rates have been relatively more stable.
In our opinion, the rise in repo rates and repo rate volatility after the second LTRO repayment suggests that Euro area money markets have already crossed the inflection point. Why are EONIA rates relatively more stable then? This has to do with the nature of EONIA. By reflecting unsecured interbank borrowing, EONIA rates capture only a small part of money market activity, which is dominated by core banks lending to each other, typically German and Dutch banks. Most of the activity in Euro money markets is secured, i.e. repos, and as such repo markets are a better reflection of money market conditions capturing a more diverse universe of counterparties including both core and peripheral banks.
Repo market volatility could be transmitted to EONIA rates if money market activity migrates from secured to unsecured markets. This migration has started happening already over the past few weeks.
Figure 4 shows that over the past four weeks volumes in EONIA have risen at the expense of repo market volumes, proxied by the traded volumes of overnight transactions in the ECB basket of the Eurex Repo GC Pooling market. As overnight repo rates approached unsecured EONIA rates at the end of June (Figure 3), certain market participants have started finding more attractive to raise overnight funding in unsecured markets transmitting volatility from repo to EONIA rates. This migration from secured to unsecured markets put upward pressure on EONIA rates in the month of July.
Put simply, as excess reserves diminish...
So there is a clearly increasing lack of trust in the interbank unsecured lending market. The inability of banks to fund themselves via this method leaves the system prone to systemic failure. Without another life-giving injection of ECB funding, this situation will only get worse... BUT there is simply not enough collateral to go around (even as the ECB slahes the quality guidelines on what crap it will accept on its balance sheet) and furthermore, banks' balance sheets will become even more encumbered by the ECB's iron fist and most-secured status should failure occur. Of course, bank stock-holders don't care that they are the ultimate first-loss in this game of cards, you BTFATH dummy!!
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