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"Size Matters" For ECB Which Runs Into Unexpected Monetization Problem

Mario Draghi’s PSPP is just barely off the ground and we’re already beginning to get answers to some of the tough questions the ECB faced regarding the program’s implementation. For instance, we wondered how the central bank intended to treat the losses it was bound to incur as a result of purchasing billions in EMU debt carrying a negative yield. The answer: try to avoid that paper for the time being. 

Another issue raised here (and elsewhere) revolves around the ECB’s ability to source willing EGB sellers. EMU banks — which hold some 20% of PSPP-eligible paper — are the most likely participants according to Goldman: 

Our view remains that the main sellers of EMU bonds to the ECB will be the commercial banks. These institutions, which in the major EMU countries own about one-fifth of the stock of government bonds outstanding, tent to care more about their intermediation margins rather than about beating a hurdle rate they have promised policy holders. Furthermore, they will face regulatory pressures to reduce the concentration of risk towards the sovereign in the country of residence. Over time, their allocation to government bonds should converge to the ECB’s portfolio composition – roughly corresponding to the GDP weights of EMU constituents.

Nevertheless, sourcing €1.1 trillion in purchasable assets isn’t easy, especially when sellers have limited options for where to park their proceeds (pay the ECB 20bps or reinvest at rock-bottom yields). Here’s Nomura via Bloomberg:

Because new bond supply “is not enough to fulfill the ECB’s targets, a substantial portion of the €1 trillion [the ECB] intends to buy over 2 years will need to come from a reduction in current investor holdings.

Overall we see €25-50 billion coming directly from euro-area investors seeking higher yields abroad while the lion’s share call it €125-150 billion will come from foreign sellers.

Of course, as Goldman notes, it’s “hard to tell” what price non-euro area holders will charge, meaning the ECB may well have to pay even more of a premium than they already plan to pay, putting their balance sheet in an even more precarious state.

This is compounded by the fact that thanks to central bank largesse, high quality collateral is becoming more scarce by the day: 

How much depth has the market lost? A year ago, you could trade about $280 million of Treasuries without causing prices to move, according to JPMorgan Chase & Co. Now, it’s $80 million.

But as it turns out, Mario Draghi may have a solution to the supply issue: buy “small” amounts.

Via Bloomberg

  • Rates trader in London says Eurosystem is purchasing bonds in trades of EU25m-EU50m.
  • Another trader in London says QE purchases of EU15m- EU25m are going through.
  • NCBs are buying govt bonds in “small clips,” Sunrise Brokers strategist Gianluca Ziglio says in e-mailed comments, citing market contacts.

Needless to say, if the ECB is unable to meet its monthly asset purchase targets (which, at €15-50 million dribs and drabs, looks likely), expect chaos, as the market has spent the last several months front running PSPP and would be absolutely horrified if DOMO (Draghi-open-market-operations) has to be downsized. Not to worry though, says Soc Gen's European rates strategy chief Ciaran O’Hagan: 

Via Bloomberg: 

“...the amount bought may be small to start with, but this will be like a pressure cooker. They've just switched on the heat and we will need some time for the pressure to mount.”

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For reference, below is a list of EMU sovereign bonds that were eligible for purchase just before Draghi unveiled the details of DOMO (note that Citi thought to create a list of 2- to 30-year EGBs yielding -0.20 and above a week before the details of the program were announced).