ECB: Funding, Collateral, Outlook

In addition to data showing a broadening and deepening of the downturn and continued stress in the money markets, the ECB will also have new staff forecasts, which will likely acknowledge the slower growth and the inflation implications of the economic outlook. A particularly soft PMI data will encourage rate cut expectations. Looking further out, it is possible that the Draghi-led ECB manages to cut rates below the 1% floor that Trichet did during the 2008-2009 crisis.

This is about 17 bln euros more than were borrowed at last week's operation, which was then the most for the year. It is about 52 bln euros more than the amount borrowed two weeks ago. The number of banks participating also rose--to 178 from 161 a week ago.

Bank borrowing from the ECB reach a new high for the year at today's 7-day repo operation. Banks borrowed 247.17 bln euros for a week at 1.25% fixed rate.

The key question is what are banks doing with those euros. The answer is that banks appear to be recycling those funds by putting them on deposit with the ECB.

There are a number of consideration behind banks' deposits at the ECB. Frequently it seems that banks build their deposits at the ECB as the month long reserve period progresses. The high level of deposits at the ECB are also seen as a symptom of the freezing up of the inter bank market. Through the reserve maintenance period, the level of euro deposits appears to have risen, especially relative to the amount that banks are borrowing from the ECB.

Through the crisis, the ECB has progressively lowered its collateral rules and is willing to accept sovereign paper even if it has lost investment grade ratings. There has been talk in recent days that Italy is trying to persuade the ECB to liberalize its collateral rules further.

There appears to be another potential solution in the works. As part of last month's agreement, there maybe an EU-wide system of state guarantees for banks is under discussion.

Recall that yesterday Greek Fin Min Venizelos indicated that the guarantees to Greek banks will double to 60 bln euros. The sticking point for an EU-wide deal is the price of the guarantee. The guarantees though may help unfreeze the inter bank market and see banks reduce the use of the ECB refi and deposit facilities.

However, this further tightens the linkages between the sovereign and private sector debt. Despite access to ECB liquidity facilities, banks have still not be able to repair their balance sheets. With sovereign and bank downgrades still looming, banks borrowing from the ECB may not be reduced greatly. It is a way to secure (funding) supply lines, even if they are not immediately needed. Moreover, reports that US money market funds further reduced EU bank exposure (another 9% in Oct), means that the ECB may be called upon to provide some of that funding that was cut.

In addition, while Greek banks and Irish banks appear to have turned to their national central banks for additional funding (ELA), which suggests they have limited ECB-acceptable collateral, that is not a problem Italian banks have. The challenge for Italian banks, in addition to having to mark their sovereign bond holdings to market,is that they have almost 90 bln euros of bonds maturing next year (the government will sell in bonds and bills some 440 bln euros).

The flash euro zone PMI readings tomorrow are likely to confirm that the economic downturn in the region continues to gain momentum.

The market seems divided over next month's outlook for the ECB, though indicative price from the OIS market shows a slight leaning in favor of a cut. Earlier this month, the ECB surprised us and many others by delivering a rate cut at the first meeting chaired by Italy's Draghi. Yesterday, for example, banks deposits 235.4 bln euros with the ECB's overnight facility.