By Owain Johnson, CME Group's head of research

The European repo markets navigated the traditionally challenging end-of-year funding cycle in an atmosphere of relative calm. But repo market participants are unsure whether that calm will persist throughout 2020.

A potential change of direction from new leadership at the European Central Bank (ECB), questions around how long negative rates can persist, and the likely impact of Brexit on UK and European policy all dominate the agenda for the new year.

Volatility levels have been relatively subdued in recent months on CME’s BrokerTec platform, which handles the majority of European repo activity. But this relative calm typically means that there will be a reaction when changes to the external environment drive European repo out of its current trading ranges.

New broom, same dust

The new ECB president Christine Lagarde faces the same challenges as her predecessor Mario Draghi: weak economic growth in Europe, the massive expansion of the ECB’s balance sheet, and the need to transition away from reliance on negative interest rates as a policy tool.

Repo volatility is driven by rate outlook uncertainty as well as by the supply and demand of funding versus collateral, and therefore both rate policy action as well as the path forward for the ECB’s balance sheet are relevant.

The question the European repo markets are asking is whether Lagarde will respond to these challenges in a different way to Draghi. Some market analysts have expressed concern that the ECB is running out of firepower, given its deposit rate is already at a record low of minus 0.5% and the bank is close to hitting limits on ownership of individual sovereign bonds.

Sweden’s central bank, the Riksbank, became the first continental European central bank to move its repo rate out of negative territory in mid-December. The Riksbank was signalling that it viewed the long-term effect of negative rates on the Swedish economy as of greater concern than the potential risk of a further economic slowdown.

The removal of negative monetary policy in Sweden after five years of negative rates may provide a clue to the broader direction of other larger European repo markets in 2020. In particular, market participants will be looking for forward guidance from the new Lagarde administration when the ECB announces its interest rate decision on January 23.

Brexit impact

The Bank of England will make its own interest rate announcement the week after the ECB on January 30. The UK, like the United States, has rates that are in positive territory, giving policymakers greater potential room for manoeuvre than their continental European counterparts. But the Bank of England is acutely aware of the potential impact of Brexit on the UK economy.

The nature of Brexit and its effect on both the UK and broader European economies is one of the main uncertainties facing repo traders this year. A hard Brexit that leads to severe economic disruption could see a return to rate cuts by the Bank of England, which would otherwise be looking at a programme of gradual hikes if the Brexit process is smooth and growth continues.

Risk appetite

European activity on the BrokerTec repo platform points to a market that is nicely poised in the early days of 2020. Global and national economic stabilisation along with a smooth resolution to Brexit could lead to more European central banks following the lead of the Riksbank and returning to a neutral or even a positive rates environment. 

Equally, slower growth or a difficult Brexit transition could see further cuts or at best a decision to maintain European rates at their current levels. The European repo market is at a crossroads in 2020, where any direction is possible and where the only certainty is that there will be change during the year.