The ECB, Eonia, QE and the EUR

It’s not just money rates in China that have been rising this week, the other notable push higher in inter-bank lending rates has been in the Eurozone. Overnight Eonia rates reached their highest levels since late 2013 on Monday. They are currently at 0.35 basis points, which is considered a stressed level as it is 10 bps above the ECB’s headline interest rate of 0.25%.

What does this mean for the ECB and the EUR?

Interestingly, the EUR has not moved higher alongside the rising inter-bank lending rate, even though rising Eonia corresponded with a stronger EUR back in December (see fig. 1). Instead EURUSD has fallen to its lowest level since November last year. One of the reasons for this is that at his meeting earlier this month, ECB President Mario Draghi said that one of the conditions necessary before the ECB would loosen monetary policy further would be tighter credit conditions that could threaten the Eurozone’s recovery. Now that Eonia rates are spiking again does the ECB need to put its money where its mouth is?

We know that the bar to more QE and further action from the ECB is high and some powerful members of the ECB, including the Bundesbank, are against looser policy. Thus, we doubt the Bank will react to the recent spike in Eonia straight away. We may need to see Eonia rise more significantly – say 20-30 basis points above the 0.25% base rate before we could imagine the ECB making plans to loosen monetary policy. At these levels we could see tighter credit conditions start to weigh on the Eurozone’s economic recovery.

Will inter-bank lending rates continue to rise?

The reason they have been rising in recent days include: 1, further payback of LTRO funds from Europe’s banks, which limits the amount of EUR In circulation (they have already paid back nearly half, or EUR 1 trillion, of 2012’s LTRO funds), and 2, a potential boost in demand for EUR ahead of tax deadlines in Italy.

We believe the latter point will only have a marginal impact on Eonia rates and repayment of LTRO funds is more important for Eonia. Banks may continue to pay back LTRO funds as they go through the ECB’s Asset Quality Review (AKA uber stress test). Thus, we could see rising levels of Eonia volatility until the other EUR 1 trillion of LTRO funds are paid back. This could be another reason why the ECB may not rush into loser policy, as they may take into account banks; reactions to the AQR, the side effect being higher Eonia rates.

The ECB and QE

While we doubt that the ECB will start cranking its printing presses straight away, there have been signs that the ECB may be getting a little more comfortable about keeping Eurozone bonds on its balance sheet. Although the overall size of the balance sheet continues to fall, the ECB has failed to sterilize bond purchases as part of its peripheral bond purchases, earlier on Tuesday the ECB offered EUR 175bn of peripheral bonds for sale and there were bids for EUR 150 bn, which leaves EUR 25bn on the ECB’s balance sheet.

This has happened at the last 3 auctions, so is it something to worry about? We don’t think so for a couple of reasons. Firstly, EUR 25bn is a very small amount compared to the overall size of the ECB’s balance sheet, which stands at more than EUR 2 trillion, secondly, peripheral bonds have performed strongly in recent months, and 10-year Spanish yields fell to their lowest levels in more than 5 years in recent days. Thus, the ECB may be happy having the left-overs on its own balance sheet if those assets are increasing in value. Thus, we are not yet reading too much into these “failed” attempts by the ECB to sterilise its bond purchases.

What this means for the EUR:

EUR has been a victim of both USD and GBP strength in recent days, which helped to push EURUSD below the 100-day sma support at 1.3572. We may have to wait until Thursday for domestic drivers to come into play when we get the first readings of January’s PMI surveys from the Eurozone. If these surveys show signs that the economic recovery is running into a road block then the markets could start to fret that deteriorating economic fundamentals combined with rising inter-bank lending rates could lead to further action from the ECB, which may trigger another leg lower in EUR.

From a technical perspective, we mentioned yesterday that 1.3525 is a critical support level (see more HERE) and if we fall below this level it could open the way to a sharper decline back to 1.3355 – the 200-day sma, and then to the November 2013 lows at 1.3295.