Our eye on a chart: in terms of liquidity, the US and the Euro area are not in the same boat, which could result in the ECB quickly becoming more constrained than the Fed in terms of QT

Published on November 2nd 2022Marché et Recherche

Stéphanie BIGOU

Portfolio Manager

Intended for Professional Clients in accordance with MIFID.

Written on 27th October 2022 by Seeyond.

In terms of liquidity, the US and the Euro area are not in the same boat, which could result in the ECB quickly becoming more constrained than the Fed in terms of QT.

As several British pension funds experienced liquidity problems at the end of September, requiring emergency intervention by the Bank of England, we find it interesting to assess the global financial risk through two ratios commonly monitored by central banks. We take the case of the United States and the Euro area, and analyze the 3-month "Ted spread" (Libor - 3-month bond rate) as a barometer of banking and credit risk, and a series of 2, 5 and 10-year swap spreads (swap rate - government bond rate, same maturities), which could represent credit and liquidity risk.

What does the data tell us?

- The US "Ted spread" has changed little and is well below the crisis and pre-crisis levels of previous cycles. In the Euro area, the Ted spread has tightened recently. However, it remains below the level of the Asian crisis of 1998/1999, the sub-prime crisis of 2007, the great financial crisis of 2008 or the European peripheral debt crisis of 2010/2011.

- In terms of swap spreads, the situation differs on both sides of the Atlantic. While the increase in swap spreads is very limited in the United States, except for the shortest maturities, it is substantial in the Euro area. All maturities combined, swap spreads in the Euro area are at historic highs, easily exceeding the levels seen at the height of major crises.

- Swap spreads have therefore tightened more than Ted spreads.

So what?

- The main common factors likely to drive up Ted spreads and swap spreads concomitantly are: 1- a macroeconomic weakening, 2- a rise in risk aversion, 3- a tightening of financial conditions. The relatively good performance of Ted spreads suggests that the economic slowdown and the rate-hiking cycle do not yet constitute a major systemic risk for the banking sector and the real economy, which is excellent news. Bank counterparty risk appears low. The strength of the labor market, rising wages, private debt levels well below past cycles, and the shortage of real estate supply should limit the extent of the recession if one were to occur, minimizing the likelihood of a significant rise in default rates. However, in the Euro area, fundamentals are more fragile, notably due to the energy crisis and the weakening of China, but the massive investment flows in renewable energies and the digitalization of economies constitute solid pillars for the labor market and demand.

- It is therefore on the side of the swap rate market and the liquidity risk that we seem to have to turn. The swap market has two main types of use:

1- large companies and/or banks that have issued and/or offered fixed-rate bonds/loans have to hedge their positions against interest rate risk by buying swap rates to exchange fixed rates for floating rates. The ultra-accommodative monetary policies of the last few years have led to a lengthening of the loans duration and a decrease in the share of variable interest rate loans, structurally increasing the demand for hedging.

2- Pension funds systematically hedge their interest rate risk -so-called convexity risk- on their commitments via government bonds but especially swap rates. In the event of quick and marked movements in rates and/or yield curves, funds are forced to drastically reduce their duration either by selling government bonds directly or by buying swap rates with a duration equal to zero. When demand is very high, swap spreads tighten.

In the US, the monetary tightening cycle seems to be adequately absorbed by the real economy and liquidity risk is low for now. The Fed seems to be in a position to continue its current monetary policy and QT. In the Euro area, swap spreads are at levels that have historically corresponded to much higher Ted spreads, suggesting a significant liquidity risk. Given the still low banking risk, there is no reason today for the ECB to stop tightening financial conditions. However, it must monitor the speed of market movements, at the risk of no longer allowing certain major financial players to function properly, and of causing indirect systemic risk. In this context, the ECB may have to slow down the pace of its balance sheet and historical liquidity provision measures reduction or postpone them partially. Thus, from a medium-term perspective, the US dollar versus the Euro could still have a bright future ahead of it.



Source: Bloomberg, Seeyond – Ted spread, Swap spreads in the US & in the EURO area - Data from December 1998 to October 2022 – Daily – last data as of 27th October 2022

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