A Record 3 Trillion Euros Is Looking for a Home

(Bloomberg) -- Banks rushing to benefit from the European Central Bank's cheap-loans facility have helped push excess cash in the euro area economy past 3 trillion euros ($3.5 trillion) for the first time.

Financial institutions increased the amount of money parked with the ECB by 1 trillion euros in under six months to 3.08 trillion euros, according to the central bank's latest update. It's due in large part to the ECB's targeted longer-term refinancing operations, known as TLTROs, that charge interest rates of as low as minus 1% to aid the economic recovery from the pandemic.

The central bank is effectively paying for the money to be lent out to households and businesses. But financial institutions can use their existing liquidity to meet the criteria needed to tap this cheap source of funding, opening the door for an arbitrage strategy with government bonds and the ECB's deposit facility, which charges minus 0.5%.

“That gives them the opportunity to engage in all kinds of carry trades,” said Rishi Mishra, an analyst at Futures First. “Short end of the sovereign bond market should be a favorite -- and even parking the funds at the ECB at minus 0.50% isn't penalizing.”

Another incentive to beef up their coffers is fear of another liquidity squeeze, the likes of which rocked markets earlier this year after corporates rushed to secure cash. A bank lending survey conducted by the ECB in the second quarter highlighted this concern. The results of the next survey will be be published at the end of the month.

“It would be incredible if the TLTRO loans haven't removed concerns of tighter credit conditions in the third quarter, otherwise it would highlight the limits of monetary policy in a crisis like this,” Mishra said.

Regardless of whether banks hoard the cash for a rainy day or lend it out to stimulate the economy, almost all of the money is stored as reserves at the central bank, boosting excess liquidity.

Funding Rates

The extra cash had already pushed the region's short-term rates to all-time lows, narrowing the difference between three-month Euribor -- the rate that banks can theoretically borrow from each other -- and the overnight rate Eonia, seen as a measure of funding stress, below zero in July for the first time since 2005.

The Euro Short-Term Rate, known as ESTR, slid 1.4bps to minus 0.57% on Wednesday, breaking the previous record low set a month ago. Euro-zone banks took 174.5 billion euros of TLTRO loans last week, adding to the 1.3 trillion euros of borrowings in June. They've also sold 559 billion euros of debt to the ECB under the pandemic purchase program.

Euro-zone inflation for September is expected to show another decline in prices on Friday, according to the median estimate of economists. While, previous large increases of cash in circulation have preempted a fall in consumer prices, Christoph Rieger, head of rates-strategy at Commerzbank AG, doesn't see a connection with the record sum of spare cash.

“The short answer is no,” he said in response to a question about rising excess cash being correlated with a slowdown in inflation. “The ECB would even argue that without the flood of liquidity, inflation would be even lower.”

The latest handout of ultra-cheap loans will only put modest downward pressure on funding rates, according to Goldman Sachs Group Inc. analysts, who estimate a one-basis-point decline in the ECB's ESTR and Eonia for every 500-billion-euro increase in spare cash.

“We continue to think that the front-end of the EUR curve is instead driven mostly by the prospect of a rate cut,” wrote strategists including George Cole.

Money markets in that respect are betting that the ECB will lower the deposit rate by 10bps from the current record low of minus 0.50% by the end of next year.

©2020 Bloomberg L.P.