In the Eurozone, we note that money-market liquidity conditions are tightening. As the European Central Bank’s bond portfolios run off, excess reserves in the banking system have fallen to €2.16tn, down around €300bn this year alone.
This has been feeding through to funding spreads, but the picture remains more nuanced. In unsecured short-term markets, the overnight ESTR is now at its widest level versus the ECB deposit facility rate since the first half of 2021. Further out, 6m and 1y Euribor-OIS spreads are broadly in line with year-to-date averages, but the 3m looks slightly elevated by around 2bp, though it was even wider in July.
Banks’ recourse to the ECB’s weekly liquidity-providing operation stands at €16.5bn, down from a local peak near €22bn in early August. That is not materially above the mostly €11bn–€18bn weekly allocations seen so far this year. Overall, conditions continue to look ample.
Still, excess liquidity will keep shrinking as the ECB lets its bond portfolios roll off, gradually tightening conditions further. That does not mean overall ECB balance sheet reduction will continue in lock-step. One takeaway from the ECB’s late-July bank treasurer survey was that banks intend to hold significant reserve buffers above their minimum requirements. Since the ECB is effectively the sole provider of reserves, stabilising liquidity (and therefore the balance sheet) will eventually require greater use of its liquidity-providing operations. The ECB itself sees these operations as an integral part of day-to-day liquidity management going forward.
Another survey takeaway, however, was that banks still generally prefer market funding, while ECB funding retains some stigma. This points to tensions ahead: at some stage someone will have to move first and tap the ECB, and some repricing may still be needed to provide that initial nudge. Timing is hard to pin down, but many already seem to be eyeing early 2027.
More importantly, tighter conditions should push secured funding rates closer to the ECB’s main refinancing rate — for overnight government GC rates, that is still a little over 10bp relative upside. For broader bond spreads further out the curve, we focus less on the ECB balance sheet size, or even excess reserves, which should stabilise at some point, and more on ECB bond holdings relative to outstanding securities.
The ECB share will continue to shrink for some time as a structural bond portfolio to offset the crisis portfolios still looks distant, and even more so as government issuance is increasing. The ECB’s share is also one of the inputs that generally feeds into the modelling of fair value levels of Bund valuations versus swaps, for instance, and therefore one factor that underpins longer-run structural cheapening views for Bunds.