Commerzbank Looks Beneath Commonly Watched Variables

It has been clear for money market pros that the real life differs a lot to the one advertised in the media.

Interest rate strategists at Commerzbank had a good look behind the scenes yesterday:

Starting with the most widely watched money market variable these days, the Libor-OIS spread, it would be wrong to conclude that ‘all is fine’ just because shorter-dated spreads have compressed below pre-Lehman levels. For most of the crisis and especially after the collapse of Lehman, liquidity has been very lopsided with banks looking to take in unsecured (Libor) cash and reluctant to lend it out, causing massive spread widening. Since central banks stepped up their unconventional measures, prompting a surge in excess reserves, however, the situation has been turned on its head. Banks awash with excess reserves are marking their bids for term cash lower to avoid getting filled with cash for which they have no use. In consequence, liquidity has moved from being scarce to being abundant but turnover still remains subdued.

Well, guys missed the fact that many governments have provided direct guarantees for inter-bank transactions, and some have promised not to allow Lehman(s) anymore. One should have faith in government criminality. Click on charts to enlarge, courtesy of Commerzbank.

A few other considerations underscore that Libor spreads are artificially depressed. First, spreads in longer-dated tenors that are less directly affected from the excess reserve pull are still significantly above pre-crisis levels and are just revisiting their pre-Lehman levels. What’s more, comparable financial CDS spreads, while also having declined noticeably, are still significantly higher than Euribor-repo spreads. For most of the crisis, the converse was true, but with the advent of unlimited ECB cash, Euribors have fallen below CDS, underscoring that the true cost of unsecured funding should be higher (see right-hand chart above).

While the liquidity imbalance is responsible for keeping Libor spreads depressed, a closer look at the dispersion of banks’ individual contributions in the € Libor panel reveals that the money market remains very segmented (see left-hand chart below) and money is not being distributed evenly.

Click on charts to enlarge, courtesy of Commerzbank.

This fact is further underscored by banks’ behaviour in ECB open market operations. Despite 1w Euribor below 0.35%, banks still demand some €70-100bn in the weekly MROs at a fixed rate of 1%. Put differently, the demand for central bank liquidity from the banking sector as a whole is larger than its need for liquidity (from reserve requirements and so-called net autonomous factors, largely bank notes). The upshot is that the excess liquidity has to be placed back with the central bank at a penalty rate of 75bp. One can safely assume that the deposits are made by different banks than those seen in the ECB operations. While no official data exists to confirm this thesis, the daily deposit facility usage is the best reflection of this phenomenon (see right-hand chart above).

Another indication that funding markets have improved but are not functioning normally can be obtained from the fx swap market. The fact that no bidder turned up at the ECB’s TAF auction last week created some headlines suggesting that the USD funding problems are over. What is true is that the ECB TAF auctions have become too expensive in terms of pricing and haircuts. In contrast to the post-Lehman shock, USD funding in Europe is available again via the fx swaps market, but it still comes at an elevated price. Judging by the 3m USD-EUR fx basis, 3m USD Libor rates should be closer to 0.75%, some 45bp higher than the actual fixing. Before the crisis, this spread was close to zero...

So much stuff behind the scenes ...