On 22 January, the ECB announced a large-scale asset purchase plan amounting to €1.140 trillion, including about €850 bn in sovereign bonds (about €220 bn in German bonds and €170 bn in French bonds). The key question raised by the plan is “Who will sell their securities to the ECB?” This is most relevant to German bonds, for which supply will barely increase in 2015. As mentioned in our previous issue (“ECB QE: a real game changer for European fixed-income), it will probably be easier for non-European investors to sell their sovereign bonds to the ECB than it will be for European investors. This is particularly likely since European banks and insurance companies (which hold, respectively, about €1.9 trillion and €1.65 trillion in sovereign bonds out of a total supply of €7.4 trillion) may prefer to hold onto their sovereign bonds for regulatory reasons (Basel III, Solvency II). This could drive the euro down even lower.
First, one clarification: non-residents who hold European sovereign bonds may be located either in the eurozone or outside it. For example, according to Bundesbank figures, over 60% of German sovereign debt is held by nonresident investors (i.e. not located in Germany), but a significant proportion of these (e.g. French banks that hold German bonds) are located in the eurozone. The problem is that the statistics for each country’s debt only distinguish between resident and non-resident debt holders, rather than resident debt holders, eurozone non-resident debt holders and non-eurozone
Based on national and ECB statistics, we have estimated the European sovereign security holdings of non-residents both in the eurozone and outside it (see chart 1). It is apparent that investors outside the eurozone only began increasing their euro sovereign debt holdings in 2006. Contrary to what some believe, investors outside the eurozone did not reduce their exposure to euro sovereign debt during the eurozone crisis, but even increased it, bringing it to around 35% of the supply. In reality, what fell sharply in 2011/2012 was cross-border intra-eurozone exposure, with eurozone banks significantly reducing their holdings of peripheral sovereign debt. Non-Europeans did not shun European bonds during the eurozone crisis. Instead, core country investors adopted a circumspect approach to the debt of countries hit by the crisis. The situation is different now: according to ECB figures, for the Eurozone, the bond markets recorded net outflows for €157 bn over the last six months (August 2014 to January 2015), which is not compensated by the net inflows recorded by the equity markets (net inflows of €70 bn).
How will this affect the euro? Halfway through 2014, foreign exchange markets began to anticipate a significant ECB balance sheet expansionand the euro depreciated sharply, especially against the dollar. However, portfolio investment flows have a strong influence over the direction of the euro. In particular, changes in the percentage of euro sovereign debt held by non-residents outside the eurozone are fairly well correlated with EUR/USD fluctuations. If non-eurozone investors actually began selling a large part of their euro bond holdings to the ECB (and the latest ECB balance of payment figures seem to indicate that this already began), the euro could fall even more dramatically. We should remember that non-eurozone investors hold mostly German and French bonds, for which yields are either very close to or even below zero.
Fixed Income and FX Strategy