Collateral Scarcity looms as ECB Waiver Nears End

Indicators suggest that traders are preparing for another episode of bond scarcity in Europe, which may diminish the effect of monetary tightening. There is growing worry that the European Central Bank (ECB) won’t extend a 0% cap on remuneration for government deposits that expires in April. This could result in some of the €390 billion of cash held by national Treasuries being shifted to higher-yielding money markets, where government bonds are used as collateral, leading to lower rates.

According to Societe Generale, Bank of America, and Commerzbank, traders may already be making preparations for this possibility and safeguarding against risk. The premium that investors are willing to pay for German two-year bonds over equivalent swaps rose in January for the first time in four months, which is contrary to the broader trend in repo markets.

Commerzbank strategists, including Michael Leister, stated in a note to clients that the extension of the waiver is “no longer being perceived as a foregone conclusion by the market,” and they point to the divergence as evidence.

The 0% cap was first introduced to prompt governments to place deposits on the market and alleviate concerns about potential monetary financing. The restriction was temporarily lifted in September to aid the ECB in ensuring that its rate hikes would reach the real economy during a time of collateral scarcity. However, since then, money market conditions have improved, with the German two-year asset-swap spread falling by over 50 basis points from its peak in September. Some believe that this should be sufficient for the ECB to stick to its plan of encouraging governments to find alternatives to central bank deposits, while others, including JPMorgan Chase, think that officials will probably opt to avoid any risk of market disruption.

Sphia Salim, head of European rates strategy at Bank of America, wrote in a note that discussions with investors in December and early January indicated that few were preparing for the return to 0% remuneration by the end of April. However, she added that these views seemed to have changed recently.

A clarity on the cap may be provided during an ECB meeting on March 16, but until then, Societe Generale strategists, including Adam Kurpiel, wrote in a note to clients that the market should continue to price in a risk premium in the swap spreads. They estimate that markets are pricing in a 33% chance of the ECB reinstating the cap.

The ECB has not given any indications of its intentions regarding the extension of the waiver. After the cap was temporarily lifted last year, Chief Economist Philip Lane stated that officials were “attentive” to the collateral scarcity concern. Any signals of the cap being reinstated as originally planned are likely to result in “strong” swap spread widening, according to Commerzbank.