Over the past two years, yields on Dutch government bonds have progressively declined to as low as -1%, driven by the accommodative monetary policy in the euro area. This means that short-term market rates have even dropped below the ECB’s deposit facility rate, which turned negative in June 2014. The decline in short-term market rates is one of the side effects of the ECB’s Asset Purchase Programme. Despite these dropping rates, the ECB retains its ability to steer short-term market rates through its deposit facility rate.
The ECB’s deposit facility rate is a referencing point in financial markets
Banks earn the ECB’s deposit facility rate (DFR) on the funds they hold on deposit at one of the central banks in the euro area (i.e. the Eurosystem). As such, the DFR represents the lower limit at which banks are prepared to lend funds; after all, the Eurosystem is the safest place for banks to hold funds. As a result, alternatives need to carry a higher interest rate. Logically speaking, the DFR should therefore act as a bottom rate in financial markets – as it used to do prior to the financial crisis. Indeed, if rates drop below the DFR, banks are incentivised to borrow at this lower rate in order to hold these additional funds at the central bank and cash out the difference (‘arbitrage’).
Short-term market rates have dropped below the deposit rate
Yields on relatively short-term government bonds of several euro area member countries have progressively dropped below the DFR since the Eurosystem is injecting liquidity through its large-scale Asset Purchase Programme (See Figure 1 and the
March 2015 DNBulletin for further information
). This progressive decline is driven by three factors: 1) rising excess liquidity, 2) the balance sheet frictions that banks face in arbitraging between the DFR and short-term market rates and 3) the Eurosystem purchases of short-term government bonds at yields below the DFR.
Figure 1 – Yields on short-term Dutch government bonds have dropped to -1%; short-term interbank rates however continue to trade above the DFR
Rising excess liquidity puts downward pressure on short-term market rates …
Under its Asset Purchase Programme, the Eurosystem buys bonds from investors that lack access to the ECB’s deposit facility through banks. Selling investors, e.g. pension funds or foreign hedge funds, receive the sale proceeds on the current accounts they hold at their banks; these banks, in turn, receive additional funds in their accounts at the Eurosystem. Generally speaking however, institutional investors prefer to avoid placing large amounts of unsecured funds at a single counterparty. This equally applies to holding cash at banks. As a result, such investors opt for alternatives like holding short-term government bonds or secured lending backed by government bonds (so-called ‘repos’). Hence, the liquidity injections produced by the Asset Purchase Programme increase the demand for this type of alternatives to holding cash. At the same time, the Eurosystem decreases their supply by taking out of the market tens of billions of euros worth of government bonds every month. Due to the increased demand and decreased supply, yields on short-term government bonds and rates on repos backed by government bonds have progressively dropped below the DFR.
… as do banks’ balance sheet frictions …
As we have seen, institutional investors are currently willing to lend money to governments and other entities (as long as they pledge government bonds as collateral) at rates below the DFR. In theory, banks should take advantage of such low rates by borrowing money and placing the proceeds at the deposit facility, arbitraging away the difference. In practice however, banks only partially do so because this type of arbitrage lengthens their balance sheet; regulations make this costly for banks. As a result, the more excess liquidity is injected and the scarcer the alternatives to holding cash become, the more short-term market rates need to drop below the DFR to keep demand and supply in equilibrium.
… in addition, the Eurosystem has been purchasing bonds below the DFR since January 2017
In search for a sufficient number of eligible bonds to purchase, the Eurosystem started to buy government bonds with yields below the DFR in January 2017. Prior to that, such purchases did not take place. The increased demand for short-term government bonds drove yields to still lower levels. That said, yields on short-term government bonds already traded below the DFR prior to these purchases, as the shaded area in Figure 1 illustrates. For this reason, purchases below the DFR can only partly explain why short-term rates have dropped below the DFR.
The DFR however remains a referencing point in financial markets
When the discrepancy between short-term market rates and the DFR increases, so does the incentive for banks to arbitrage. Simultaneously, institutional investors are incentivised to switch to other short-term assets or accept a broader range of collateral in secured lending transactions or to lend more funds unsecured. As a result, the DFR remains a referencing point in financial markets. Accordingly, the ECB retains the ability to steer short-term markets rates through the DFR.
