ECB’s loan package to give European funding markets a break

Bloomberg

European funding markets have thus far been stubborn in correcting. This may be about to change.
A new European Central Bank (ECB) loan facility for tackling the pandemic, known as PELTRO, will be allotted. The interest rate will be 25 basis points below ECB’s main refinancing operations, currently 0%.
While it’s less tempting than the upcoming TLTRO III, another ECB loan package to be allotted on June 18, it should be attractive to banks which may be constrained from taking part in other programs, Citigroup Inc.’s Andrea Appeddu wrote in a client note. The aim is for this “well-priced liquidity backstop to further support liquidity conditions in all segments of the euro area financial system and contribute to preserving the smooth functioning of money markets,” he wrote.
Euribor fixings will be pushed lower, and subsequently euro FRA-OIS — a barometer for interbank risk — will also dip from the current elevated levels.
Analysts have expected this outcome and partly attributed it to the term structure of euro FRA-OIS, which shows a steady tightening back to normal levels by year-end.
There’s another side effect of these new loans: the return of carry trades.
“TLTROs are a clear invitation from the ECB for banks to buy high yielding front-end bonds, financed by cheap money, and essentially funding the government’s pandemic spending, much of which will be done through bills for the time being,” Giles Gale, NatWest Markets Plc’s head of European rates strategy, wrote in a client note.
It already appears in motion with the yield on Spain’s three-month bills falling to -0.4% from near 0% in April.
Three-month Euribor fixings remain elevated, jumping 1.7 basis points to print at minus 0.259%. However, the euro FRA-OIS spreads edged tighter again on the same day, reflecting improved risk outlook after a Germany-France agreement to support a rescue package to help the European Union.
This has led to an unwind of risk-off type trades, as shown by a sharp tightening in spread between two-year German sovereign bonds and interest rate swaps, a classic risk hedge.
The three-month dollar Libor slid for a 22nd straight session, though at a slower pace, with the fixing down by 0.3 basis points to 0.37413%. The spread over overnight index swaps — a commonly used indicator for banking risk — was a touch tighter at around 31 basis points.
The slowing pace of decline reflects a catch-up to commercial paper rates which have collapsed around 180 basis points from the March high to hover near 0.25%.

Issuances in longer-dated financial commercial paper markets are still full steam ahead.
After breaking a six-week deadlock on May 7, there have been new sales every day since, recording another seven on May 18, according to the latest Fed data. This brings the running total since the restart to over $1 billion.