An ECB rate cut this week would limit moves in the money market in future but may also prevent borderline healthy banks returning to the market and dull its appeal for others. While the European Central Bank is widely expected to cut its main interest rate to a record low 0.5 percent on Thursday, market prices show investors believe it will keep its deposit rate at zero for the foreseeable future.
That would soothe the concerns of those who warn a negative deposit rate could wipe out unsecured lending market, but would also narrow the corridor between the main rate and deposit rate in which money market rates move. With so much cheap ECB money in the system and key bank-to-bank lending rates at just 0.2 percent, the change is unlikely to matter until liquidity levels drop and market rates begin to move more freely again.
In the last few years, the ultra-easy conditions created by the ECB mean interbank rates hardly budge even during a flare-up in the euro zone crisis. "It is a story for the future really, but what it (a rate cut) does is lower your effective ceiling for market rates," said Nomura rate strategist Guy Mandy. "In that lower-for-longer environment volatility should be dampened but there are still risks in that Europe is still not a safe place."
Though worries about the future of the money market remain centred on the slim chance the ECB cuts its deposit rate, academic research suggests narrowing the gap between the main and deposit rates can restrict lending. Research by Ulrich Bindseil, head of the ECB's market operations department, shows that the tighter the corridor, the more banks tend to borrow from the central bank rather than on the open market. Trading turnover roughly halves if the gap narrows from 75 basis points to 25.
"Initially, in a zero corridor regime, there is no interbank trade independently of the level of transaction costs. As the corridor gets wider, interbank transactions appear more profitable and interbank trade kicks in," one paper concluded. Some economists expect a further rate cut later this year. In that case, if benchmark three-month market rates remained at 0.2 percent as expected, the risk reward would be minimal and the option to borrow from the ECB at 0.25 percent might be too tempting for some to pass up.
But traders say the theory ignores the heavy stigma within the banking community attached to borrowing from the ECB. "The incentive banks have to go to the unsecured market is not about the rate, it is about not depending on official aid and not having to pledge collateral," said one euro zone-based money market trader who requested anonymity. "In my eyes, the approach of saying the unsecured market will suddenly become less attractive because the ECB will be at 0.50 as opposed to 0.75 percent doesn't make any sense."
Analysts say that it is the banks in Greece, Spain, Portugal, Italy that remain most dependent on the ECB for their funding who will be the biggest winners from a rate cut. Not only will they get cheaper funding but the money they borrowed in the ECB's two three-year LTROs will also become cheaper as the rate on those loans tracks the refi rate.
But for banks recovering from the worst effects of the crisis, it could delay attempts to return to the open market. "For most of us we are just not lending to those (periphery) banks it is as simple as that," said one London-based trader. "But are those banks realistically going to get a lower rate than 0.5 percent? Probably not."
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