ECB Rate Cut Affecting Euribor: German Bond Yields To Fall Further

by: Katchum

On Thursday, July 5, 2012, the ECB cut its main refinancing rate to 0.75% and its deposit rates to 0%. After LTRO I and LTRO II, we have another stimulus to supply credit to the markets.

In my previous article on LTRO I, I noted that the Euribor was manipulated lower by this Long Term Refinancing Operation (LTRO) to make it more easy for the banks to lend by supplying them with cash to be paid back within three years (see Chart 1).

Click to enlarge

Chart 1: 3 Month Euribor

But it wasn't working out for the markets, because all the money was kept at the ECB deposit facility (see Chart 2). A record 790 billion euro was parked at the ECB.

Chart 2: ECB Deposit Facility

As an alternative of LTRO, we got the interest rate cut of the ECB, and that lowered the Euribor another step from 0.64% to 0.55% as witnessed on Chart 1 (see the little spike downwards). What this will do is not supply banks with extra cash, instead it will force banks to use their cash deposits at the ECB and force them to lend.

What is euribor? The definition on the Euribor site gives:

Euribor is short for Euro Interbank Offered Rate. The Euribor rates are based on the average interest rates at which a panel of around 50 European banks borrow funds from one another. The Euribor rates are considered to be the most important reference rates in the European money market. The interest rates do provide the basis for the price and interest rates of all kinds of financial products like interest rate swaps, interest rate futures, saving accounts and mortgages. That's the exact reason why many professionals as well as individuals do monitor the development of the Euribor rates intensively.

To put it simply, euribor is the interest rate at which banks lend to each other and it sets the mortgage market, interest on your bank account, lending rates.By lowering the ECB refinancing rate, we basically have executed a pseudo LTRO III. By lowering the deposit rate to zero, we basically have put a lid on the growing cash deposits at the ECB (see Chart 2). Banks won't be so keen on parking money at the ECB with zero interest rates. Instead, I believe, banks will now use the 790 billion euro in deposits to buy government debt, which are already in negative territory for some countries like Switzerland and Germany.

For example, the two-year German Bond Yield fell into negative territory on July 6, 2012, for the first time in history (see Chart 4). So it isn't a bad idea to buy into bonds of safer countries like Germany and Switzerland, or even Belgium.

Chart 3: 10 yr German Bond Yield

Chart 4: 2 yr German Bond Yield

Finally, to my surprise, banks are acting very quickly on this rate decision. My personal bank has lowered its deposit interest rate from 1.65% to 1.5% days after the ECB rate cut. Surely, I am not putting my money in my bank account with these rates. I suggest European investors do the same. They can buy for example stocks, precious metals, real estate, even European bonds of safe countries like Germany and Switzerland. What they shouldn't be doing is holding euros, as it will go down against other currencies in the short term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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