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How The ECB Is Distorting Euro Money Markets

As we continue to pound the table about the effects central bank asset purchases are having on market liquidity, it’s nice to know that there are at least a handful of people out there who agree that maybe — just maybe — depriving the market of high quality collateral by monetizing everything that’s not tied down could serve to destabilize markets and may indeed introduce systemic risk. The list of those speaking out on the issue has grown with the size of central bank balance sheets and has recently come to include SEC officials, BoJ officials, and investment banks. Here’s what we said on Thursday

As central banks work to monetize all net (and sometimes gross) government bond issuance in their respective jurisdictions [they destabilize] markets by sapping liquidity which in turn inhibits price discovery and creates volatility. This is on display in Japan, where 2 out of 3 dealers think the JGB market is impaired thanks to BoJ asset purchases and where many officials are beginning to get more vocal about the possibility that a lack of liquidity could have “dire consequences.” Similarly, market financing via shadow banking conduits has declined by nearly half since 2008 in the US, and with dealers unwilling to hold inventory of corporate paper thanks to tougher capital requirements, the stage is set for what the Center for Financial Stability recently called “an accident.” As a reminder, here’s what  the SEC's Daniel Gallagher had to say recently about liquidity in the US corporate bond market (via Bloomberg): “Lack of liquidity in corporate bond market is ‘systemic risk’ not addressed by regulators, SEC Commissioner Daniel Gallagher says in public remarks.”

Even as the Fed has wound down asset purchases in the US and may be set to raise rates later this year (which, as UBS recently noted, may cause corporate spreads to widen against a backdrop of limited liquidity in the corporate bond market), the ECB is set to inject more than €1 trillion across the eurozone on the way to monetizing three times net euro fixed income issuance. Here, courtesy of Barclays, is what this means for euro money markets: 

The ECB’s liquidity bazooka will push the surplus to more than €1trn by the end of the programme next year and cause a scarcity of high quality collateral in the repo market. We see still room for a further decline in euro short rates into negative territory. This would be very challenging for Euro Money Markets investors… 

 

The development of the repo rates would be very interesting as, in addition to the massive increase in liquidity, the collateral scarcity effect owing to the displacement of government bonds caused by the ECB’s QE should exacerbate the downward pressure on GC rates. Importantly, banks’ need of high quality collateral to meet the LCR requirement should increase the demand/supply imbalances. In particular, this applies to core paper that should be affected also by the expected very low net supply of government bonds. In such a context. even if the ECB set the depo facility rate (currently at -20bp) as a threshold for its purchases of bonds with negative yield, we would expect core GC to richen vs. Eonia and to trade even below the depo facility rate. Peripheral GC should decline as well, and we would expect them to continue to trade flat vs. Eonia, with some spreads vs. core paper. Importantly, the shortage of government bonds would reduce the liquidity of the repo as well as cash markets. In the legal act of its public sector purchase programme (PSPP) the ECB stated that securities purchased under the PSPP are eligible for securities lending activity, including repos. This will be very important, in our view, to mitigate any negative implications of QE purchases on the repo market’s functioning. 

 

...the ECB’s liquidity bazooka will likely create the conditions for all rates money markets to stay in negative territory. This would represent a very challenging environment for investors, especially those focusing on the euro money markets, whose resilience to negative rates has not fully tested yet. Indeed until the beginning of this year, with the liquidity surplus not big enough to fuel significant downward pressure on the Eonia fixing and with high uncertainty of the size of the ECB’s QE, investors were able to manage the negative rates environment and get some positive yields thanks to the increase in duration/credit risks. This year we would expect it to be much tougher as the opportunities to invest at positive yields/rates are much more limited, as also peripheral t-bills are likely to move gradually into negative territory. It is hard to predict how much yields/rates could go negative in the current context. The ECB’s depo facility rate represents a floor for Eonia and Euribor rates, but not for GC rates and bills/short-term bonds yield, as supply/demand imbalances exacerbated by the ECB’s QE-induced displacement would create potentially unlimited room for reaching vs. Eonia. 

 

Euro Money market funds are likely to be severely hurt as regulation and rating agencies force them to focus on the very front end of the money market curves and limit their exposure to issuer/asset classes. So, to some extent, they are being forced to continue investing in euro-denominated assets at negative yields.

In a nutshell: short-end core paper will trade below -0.20%, extreme supply/demand imbalances will cause general collateral rates to trade through the depo rate, money market fund yields will turn decisively negative testing investor patience, and central banks had better make good on promises to make some of their inventory available for lending or risk impairing the functioning of the repo market (never a good idea). 

 

Barclays also notes that PSPP purchases will have a “very large displacement effect”: 

The key takeaway for the EGB market is that c.€45bn per month in EGB purchases for at least 19-months is a very large number for the EGB market and its investors to absorb. Therefore, the portfolio squeeze effect of the purchases could be quite large. Taking into account our estimated monthly average net issuance for EGB issuers, we conclude that ECB buying will outweigh net issuance for each of the sovereigns and displace investors. Indeed, in aggregate terms the ECB is aiming to buy up to €850bn cash in EGBs during the whole programme in the eligible QE bucket (2-30y). This, together with our estimated €290bn net EGB issuance in this bucket over the course of the programme, means that the if ECB’s QE is to meet its balance sheet expansion target, it will potentially displace c.€560bn from the EGB investors. In comparison, the Fed purchases of Treasuries never exceeded net issuance. Even in the recent purchase operations, where the Fed has focused on the long end, private investors did not have to lower their holdings of long end Treasuries. As such, the ECB’s purchase programme is more likely to resemble the Japan experience under QQE, where annual purchases of ¥50trn (later scaled to ¥80trn) far exceeded annual net issuance of around ¥38trn.  

 

That’s just the EGB portion of the program. In total, some €840 billion of bondholders will be displaced...

 

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What should be clear from the above is that while central banks’ ability to alter inflation expectations and/or stimulate aggregate demand may be limited, their ability to distort markets, inhibit price discovery, and create systemic risk is alive and well.