4 Min Read
* Better funding costs to revive short euro primary
* Issuance to relieve supply squeeze
By Matt Painvin
LONDON, March 17 (IFR) - After shunning the short-end of the euro market in recent years, public sector issuers could finally be tempted back, lured by an improvement in funding costs and investor cravings for an alternative to expensive short German government paper.
Divergence between monetary policy in the US, where the Fed began to taper in December 2013, and in Europe, where the ECB started asset purchases in March 2015, has contributed to a widening of the cross-currency basis swap.
That made it attractive for Europeans to skew their short-dated borrowing towards US dollars, while reserving the euro option for duration.
In 2016, the EIB raised US$21.8bn in dollars from up to six-year maturities against only €7bn from euros in the same tenors. Germany's KfW issued US$37.5bn and €5.2bn in maturities of less than five-years during the same period.
The maturity split between the two currencies has allowed European SSAs to run complementary funding programmes. "US dollars and euros are core funding currencies for EIB," said Sandeep Dhawan, EIB's head of dollar funding.
Short-end SSA issuance may have been thin, but there is latent interest for paper, especially with core governments trading so expensively.
"There is definitely some demand for short euro assets as investors look for alternatives to Germany to capture some extra yield," said Lee Cumbes, head of public sector origination at Barclays.
The World Bank issued a US$4bn three-year benchmark at mid-swaps less 4bp this week. With the current basis swap that would have come out around -0.48% in fixed euro terms, while three-year Germany was trading at -0.69%.
"There is some demand from European bank treasuries in three-years," said another banker. "However, the book would be almost exclusively European."
The reduced supply is not just a result of European SSAs focusing on US dollars. The ECB's Targeted Long term Operations have provided attractive funding to European banks in tenors up to four years and dramatically reduced issuance at that part of the curve.
That, combined with the ECB's asset purchase programme being expanded to maturities as short as one-year in December 2016, lies behind the squeeze in short-dated government bonds.
The two-year German Schatz yield collapsed to -0.94% in late February as investors, especially money market funds and bank treasuries, competed with the ECB for paper to fulfill their needs for high quality short assets.
With some natural demand, recent basis swap moves could be the trigger that helps bring issuers back to the single currency.
There were two main reasons for the widening in the US dollar/euro basis swap late last year.
Firstly, a structural shortage of dollar funding due to the US money market fund reforms enacted in October. And secondly, strong US dollar demand after Trump's election in November as investors anticipated a sharp strengthening of the currency.
But this year, those factors have begun to reverse and the basis has tightened back. The three-year swap has moved 10bp off its January 17 low, to around minus 38bp.
"The short-end still works but the differential is smaller, affecting arbitrage," said Cumbes. "The tightening brought the breakeven between markets shorter on the curve."
For some issuers though, improving funding costs might not be enough given that negative short-end euro yields narrow the universe of potential buyers.
"Bank treasuries can buy negative yields but it is trickier for asset managers and central banks," said Joakim Holmstrom, Municipality Finance's head of funding.
"As an issuer, we prefer to ensure a granular placement." (Reporting by Matt Painvin, editing by Helene Durand and Julian Baker)