Stock - ECB
Image Credit: Bloomberg

A key measure of risk in European bond markets is set to extend its decline to multi-year lows after the central bank revised the way it sets interest rates, reducing the room for arbitrage between its main benchmarks, according to Natixis SA.

By trimming the gap between the deposit and refinancing rates to 15 basis points from 50 basis points currently, the European Central Bank will effectively limit the scope for fluctuations in bank funding costs and curb volatility. The change was announced this week and is set to go into effect in September.

According to Benoit Gerard, a strategist at the French lender, that in turn should further narrow the gap between the rate on German interest-rate swaps "- which incorporate an element of counterparty risk "- and the yield on equivalent bonds, among the region's safest assets.

The difference between the two, known as the swap spread, has shrunk since mid-2022, falling to the lowest the lowest in almost three years. So far, most of the repricing has come as the ECB trimmed its holdings of highly-sought German bonds, pushing yields higher relative to swaps.

"Current levels on Schatz, Bund swap spreads could now act as a ceiling and not a floor," he said. "This is positive for risk."

German swap spreads in the 10-year tenor tightened from over 100 basis points in mid-2022 to 30 basis points, the lowest in almost three years.