Cooling Interest Rate Cut Expectations
After months of policy easing, the European Central Bank's monetary policy path is entering a new phase. Although the market once firmly believed the easing process would continue, recently, investor expectations for further rate cuts have significantly cooled. Pricing in the interest rate derivatives market indicates that the possibility of further rate cuts has been reduced to a limited level, with most institutions predicting very little room for "one more cut." This is because, although economic growth expectations have not improved significantly, the risk of recession is not widely acknowledged for now. Coupled with the active brewing of fiscal policy, the space for monetary policy operations is constrained.
Repricing of Funding Market Structure
As balance sheets gradually shrink, the main line of the European funding market is undergoing subtle changes. Previously stable short-term rates and converged volatility are shifting, and medium to long-term funding spreads are more likely to be under pressure in the future. Euribor-OIS, IRS/OIS, and repo basis are regarded as key indicators. Their changes reflect not only the changes in the banking system's liquidity but also the market's reassessment of policy sustainability. Analysts point out that future spread trends are more like a "slow climb" rather than a sharp fluctuation.
Gradual Decline of Excess Liquidity
The current scale of excess liquidity in the eurozone banking system remains high, but it is moderately declining. As market-based financing channels remain open, banks' reliance on central bank operations is limited, keeping the subscription volume for regular liquidity operations low. Looking ahead, as bond portfolios mature naturally and refinancing arrangements gradually decrease, the level of excess reserves is expected to fall further. The market generally expects that by 2027, excess liquidity will drop to around 1.5 trillion euros, considered a long-term steady-state level. This evolution suggests that the banking system will gradually rely on market financing, and the central bank may moderately adjust its tool design.
Structural Operations May Become the Norm
In previous framework assessments, the European Central Bank has hinted at the possibility of replacing excess liquidity with structural refinancing tools in the future to provide a flexible ceiling for the market. Unlike the current full-allocation fixed-rate operations, these tools are more inclined toward limited tendering, helping the market to once again decide the term premium. At the same time, regulatory factors are subtly changing banks' liquidity preferences. As liquidity coverage ratios marginally decline, banks become less reliant on central bank reserves, preferring to maintain compliance indicators through other high-quality liquid assets.
Repo Market Remains Stable
In the repo sector, although transaction volumes have recently declined, overall rates remain closely aligned with the deposit facility rate fluctuations. Although the spreads between different collateral types have changed, there have been no stress signals in the overall market. The local steepening of the repo rates curve for German and Italian government bonds reflects more fiscal policy expectations and supply pressures rather than systemic risk. This indicates that even as balance sheet reduction progresses, the market still tends to meet demand through direct financing rather than relying on central bank lending.
Outlook and Risks
Overall, the next phase of euro term basis trends will gradually unfold under the triple influence of policy, liquidity, and regulation. If inflation falls more slowly than expected or if fiscal stimulus is implemented sooner, the curve may steepen more quickly. If the central bank's tool blueprint becomes clearer, market pressure may be alleviated. Analysts generally believe that "one more cut" is still possible, but the probability and extent have significantly narrowed. What will be more noteworthy in the future is how the spread reflects the competition between market-based financing and central bank tools during balance sheet reduction.
