Europe’s Money Markets Prepare for World Without Unlimited Cash

(Bloomberg) -- A key gauge of funding conditions in Europe suggests money markets are pricing in an eventual end to the region's unprecedented liquidity glut.

The premium banks pay to pocket the spread between three-month and overnight cash in two years' time, rather than September, has climbed to six basis points. That's triple the equivalent level back in February and up from a low of around minus 15 basis points during the depths of the coronavirus crisis last year.

The sharp repricing in the shortest end of the curve -- the most sensitive to shifts in monetary policy -- comes even as excess cash in the system jumped above 4.25 trillion euros ($5 trillion) for the first time ever this week. The increase was spurred by the European Central Bank's hefty bond purchases and liquidity injections designed to lessen the blow of the pandemic.

It's a sign traders are already preparing for the torrent of central bank cash that is pinning down short-term borrowing costs to be scaled back as economies begin to recover. That would be a sea change for markets that have been riding the wave of extraordinarily loose policy for years, deploying the money to buy financial assets and take on risk.

The region's spare cash pile will peak at almost 5 trillion euros in the second half of 2022 before retreating, according to Benjamin Schroeder, strategist at ING Groep NV. Yet he notes that if banks begin to repay cheap loans to the ECB in September, it could drive up interbank lending rates sooner than the market expects.

“My hunch would be that this is what the upward sloping FRA/OIS strip is already pricing in,” Schroeder said.

The ECB's Pandemic Emergency Purchase Program -- or PEPP -- will be phased out in March. And the last Targeted Long-Term Refinancing Operation, by which the ECB provides commercial lenders ultra-cheap cash, is due in December.