Warped German Rates and Scarcity of High-Quality Paper: Analysis

ECB action on collateral lending could ease the squeeze.

Persistent stress in Europe’s repo markets is highlighting the scarcity of high-quality assets for use as collateral, which will worsen as the European Central Bank continues its public-sector debt purchases, Bloomberg strategist Tanvir Sandhu writes.

Scarcity of bonds in repo is reflected in the recent widening of the schatz-eonia and deposit rate-general collateral spreads. Demand for collateral is more of an issue at the front end of the German yield curve and schatz-eonia would cheapen if the ECB were to addresses the scarcity. Euro cross-currency front-end basis is now near the lowest levels since 2012 as dollar funding pressure increases over year-end, adding to demand for euro collateral.

The ECB could induce tighter short-end spreads by lending purchased bonds against a wider range of collateral. The central bank may eventually implement changes to the way its lending facilities operate, by altering the minimum fee charged and the borrowing limits per counterparty, given that a functioning repo market is essential to guarantee short-term funding for non-banks.

A removal of the deposit-rate parameter on ECB PSPP purchases may further squeeze German general collateral and increase the specialness of the front-end of the German curve. The recent steepening of the bobl put option skew signals investors hedging against potential disappointment should the ECB refrain from removing the deposit rate floor while the collateral squeeze persists.

Structural factors have kept the schatz-eonia spread rich, given increasing regulation, demand for high-quality collateral and corporate cash shifting into front-end German paper versus bank deposits.

NOTE: As of November 15, the ECB’s securities lending arrangements allow eligible counterparties, at any time, to borrow securities at a fixed minimum fee of 30 basis points, or a fee based on prevailing market rates, whichever is the higher. The fee is the difference between the repo and reverse repo rates. Subject to availability, an individual counterparty may borrow up to 2.5 percent of the amount outstanding of a single issue (as identified by the ISIN), with a maximum of 200 million euro ($212 million) for any such issue. (web link: see more here)

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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