EUR Money Markets: Tightening As Intended

(MENAFN- ING) ECB pricing is looking increasingly stretched

The European Central Bank faces a challenging backdrop of renewed energy market stress alongside surprisingly resilient economic growth, as reflected in the latest flash PMIs. This mix has pushed short-end rates to price in a tightening cycle that sees three to four more hikes over the next year. We think this is too much and expect only one more hike from the ECB, taking the deposit facility rate to 2.75%. But we have to acknowledge that this outlook largely hinges on the assumption that geopolitical tensions will start to ease after the US mid-term elections.

Liquidity conditions tighten and approaching critical thresholds

Money markets face progressively tighter liquidity conditions as the ECB continues to shrink its balance sheet and transitions to a new operational framework for implementing monetary policy. The new framework, introduced in 2024, aims to nudge banks into a more active role, using liquidity operations as part of the ECB's day-to-day liquidity management. The ideal is a self-balancing system where banks decide how much liquidity they need while the ECB continues to offer unlimited liquidity at a fixed rate.

By design, as excess liquidity continues to decline, short-term rates are expected to rise. The indicator the ECB appears to watch closely is the repo market. Officials have indicated that repo rates moving toward the rate charged on the ECB's one-week main refinancing operations (MROs) would be consistent with the framework functioning as intended, since banks would increasingly have economic incentives to substitute market funding with ECB refinancing operations.

At a later stage, the ECB plans to introduce both structural refinancing operations and a structural bond portfolio aimed at supplying a baseline level of reserves. The objective is to cover the structural liquidity demand arising from reserve requirements and autonomous liquidity factors such as banknotes in circulation.

One issue that the ECB has not yet solved is that funding via the ECB comes with a perceived stigma. That is what could lead to a more noticeable squeeze higher in money market rates.

Excess liquidity is at €2.12tr at the moment. Current estimates suggest banks may wish to operate with somewhere between €1.5tr and €2tr of excess liquidity, although uncertainty remains substantial because observed reserve demand under the new framework is untested. The estimates hinge on assumptions around liquidity coverage ratios that banks want to maintain and the share of reserves within the portfolios of high-quality liquid assets backing those ratios. Nevertheless, these estimates suggest that repo funding rates could begin to rise more noticeably from late 2026 into 2027. Banks with relatively smaller liquidity buffers or less active access to repo markets may experience funding pressures earlier than the system-wide aggregates would suggest.

While we think there is only a low probability of it happening, the process could accelerate if the ECB follows through with proposals to increase the minimum reserve requirement from 1% to 2%. This would immediately absorb roughly €176bn of liquidity from the banking system. The rationale is to lower the ECB's losses stemming from paying interest on the liquidity created by the bond-buying programmes. Reuters reported in July on alternative options, such as not paying interest to banks on some of their excess reserves, ie applying a tiered rate, or even charging fees.

Banks aren't yet feeling the pressure to go to the ECB for liquidity Source: ECB, ING

"> Funding markets tighten as they take over liquidity redistribution

We are already seeing the €STR unsecured overnight benchmark drift higher, but it still stands 6bp below the deposit facility rate. If we take the latest ECB Survey of Monetary Analysts conducted ahead of the September ECB meeting at face value, then €STR should stabilise around 5bp below the deposit facility rate. Since €STR is not a pure interbank rate, but rather reflects wholesale unsecured borrowing by banks from a broader set of financial counterparties, a negative spread relative to the deposit facility rate can persist as these counterparties do not have direct access to ECB facilities.

Further out the funding curve, we see the 6m Euribor/€STR-OIS spread implying banks are willing to take on unsecured term funding slightly above the implied MRO rate, which sits 15bp above the deposit facility rate: 6m Euribor/€STR-OIS is at 29bp, while the MRO rate is 21bp above €STR.

To be fair, they are not perfect substitutes. Euribor is unsecured whereas MRO borrowing is collateralised. However, the persistence of a positive spread also suggests that banks continue to attach some value to avoiding direct recourse to ECB funding.

Overnight repo rates have continued to drift very gradually higher over the past months and are now largely above, but still close to, the ECB's deposit facility rate.

Funding rates continue to gradually drift higher Source: ECB, Refinitiv, ING

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At the same time, repo market activity has increased materially. Volumes captured by benchmarks such as the STOXX GC Pooling overnight index are already close to levels last seen in 2014, before the asset purchase programmes began injecting substantial liquidity into the banking system. This suggests that liquidity redistribution in money markets is becoming increasingly important as excess liquidity declines, consistent with the ECB's objective of encouraging a more active role for market-based intermediation.

Note that, looking further out to 1y, term GC rates against German and Italian government collateral remain below the implied MRO rate. This suggests market participants still expect liquidity redistribution through private markets to remain sufficient, without widespread recourse to ECB refinancing operations.

Money market secured and unsecured curves versus OIS Source: Refinitiv, ING

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The upcoming year-end will provide another important test of liquidity conditions, as balance-sheet constraints typically reduce market-making capacity and increase funding demand. Funding markets may face additional pressure precisely as concerns surrounding European sovereign debt sustainability have re-emerged.

In particular, elevated political uncertainty in France raises the possibility that sovereign-bank linkages receive greater market attention. While French GC curves have only widened modestly so far, government bond spreads have reached their widest levels since 2012. At this stage, markets appear to be pricing in political uncertainty rather than fundamental default risk. Five-year French CDS spreads have risen sharply but remain below the levels observed during the 2017 Frexit episode.

Liquidity conditions are likely to continue tightening as QT steadily reduces excess reserves in the banking system. The base case remains an orderly tightening, with the repo market absorbing redistribution and repo clearing moving toward the MRO rate. The risk of a disorderly squeeze is most acute if the minimum reserve requirement is raised simultaneously with continued QT, or if a bank-specific liquidity event forces recourse to ECB facilities and triggers stigma-related contagion.

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