ECB QE: a real game changer for European fixed income market

ECB QE impact on EUR fixed income market is likely to be significant; three main factors point to this conclusion:

1. The size of announced QE is remarkable as it represents around a fifth of Eurozone sovereign bond market and more than 10% of overall fixed income debt;
2. ECB QE comes at a time of very limited growth of Eurozone fixed income debt and net supply of new bonds projected for 2015 is unlikely to cover for the overall purchase program of the ECB;
3. Contrary to other jurisdictions’ QE experiences, negative rates on banks’ deposit facility at the ECB amplified the effect of growing QE expectations and greatly contributed to push short to medium core government bonds into negative yield territory: this should intensify the search for yield on remaining spread oases left to investors.

Size matters but debt market dynamics matter even more: let’s consider Fed QE1, too

As announced by the ECB, the QE program will total € 1,140 billion purchase volume over the next 19 months, starting in March 2015 and ending in September 2016. The program will address central government bonds, ”quasi government bonds” (namely, agencies and supra-nationals), covered bonds and ABS. The ECB specified that the government and quasi government bonds it will purchase would be rated investment-grade (IG). The size of the European IG fixed income market, including EUR IG corporate bonds, is currently close to € 9.5 trillion: most of these instruments are sovereign bonds (around 60% of the entire market), then 17% are IG corporate bonds and the remaining part is made by covered, agencies, supra-nationals and ABS. At first sight, therefore, ECB demand represents slightly more than 10% of the current overall fixed income market and is close to 20% of the sovereign bond market only. With respect to Fed QE1 purchase volume, this “firepower” looks slightly less, as Fed first QE volume totaled about 15% of initial market size in which it started. If QE2 and QE3 volumes are added to the computation, Fed total intervention appears much more heavy in relative terms, as holdings of Treasury securities currently held by the Fed represent more than 21% of the US Treasury market.

However, mere absolute and relative numbers may be misleading if market dynamics are not appropriately considered. Fed QE1, in fact, took place at a time when, in order to sustain growth, US fiscal policy turned to an unprecedented expansionary path, more than compensating for concurrent private sector’s deleveraging trends. If major segments of US fixed income markets are considered all together, the size of US IG bond market actually increased by a remarkable 50% in just two years (2008 and 2009), rising from around $ 10 trillion to $ 15 trillion debt value when the Fed QE1 took place.
Therefore, it’s not wrong to argue that the impact of Fed buying volumes was greatly diluted within an unprecedented rise in federal and public sector debt. In reality, with its QE policies, the Fed had only restore its position on the US Treasury market: while it owns currently 21% of the Treasury market, it already owned around 20% of the US Treasury market before the Great Recession.

The situation differs greatly in the Eurozone: ECB will buy bonds from a market whose size is expanding very slowly. Banks’ multi-year deleveraging, companies’ persistent cautiousness in expanding debt levels, tighter fiscal policy on the back of the sovereign crisis and weaker credit demand arising from households battered by recession were all factors limiting EUR bond market expansion over the last years, as we already outlined in the previous section. For instance, the net issuance of long term sovereign bonds has been only slightly above € 200 bn in 2014, i.e. three times less than the sovereign bonds that the ECB would buy if we make the assumptions that 50 of the €60 bn of monthly purchases concern sovereign bonds. At the same time, though a limited recovery of Eurozone credit volumes should take place in the next two years, a remarkable expansion of debt volumes looks highly unlikely. Banks will surely prove more prone to tap the bond market, also for regulatory reasons, fiscal policies will result less tight and the companies’ credit cycle will finally re-start, but these trends will fail to provide a net issuance of new debt enough to counterbalance the monthly EUR 60 bn purchases from ECB and NCBs. The big difference between the ECB’s and the Fed’s QE is that the ECB will take a (massive) position on the sovereign bond markets that it had not had previously.

Negative rates on banks’ liquidity to reduce persisting financial fragmentation

Together with lower growth of primary debt market another factor is at work to make ECB QE impact on EUR fixed income market quite remarkable: this factor is represented by negative rates on banks’ deposit facility. Last June, in fact, the ECB entered a sort of “uncharted territory” before recently moving to full QE: at that time, the rate on deposit facility was lowered to negative levels, namely to -10 bps In September a second cut came and since then liquidity deposited by banks with the ECB has been charged at a rate of -20 bps. The latter September decision contributed to trigger an almost immediate yield fall of short term core government bonds in negative territory. Over the last months, this fall moved on from the very short maturities (let’s say two and three years) to intermediate maturities: as we are writing and as the graph shows, all core sovereign bond yields are negative up to 5 yr. Negative rates are a monetary policy tool actually missing in Anglo Saxon and Japanese QE experiences: though QE volumes put in place by Fed and BoE proved to be much higher in relative terms with respect to GDP or debt market size, US Treasuries and UK Gilts always traded above 0% yield. Even Japanese government bonds remained in slightly positive yield territory over time, if we exclude a few weeks between last year end and this year start.

It is true that according to a Fed paper (“Four stories of Quantitative Easing” – Fawley, Neely – Federal Reserve Bank of St. Louis Review, January/February 2013), “Because people can always hold currency instead of depositing it in a bank, short-term nominal interest rates cannot go (much) below zero, which limits the effectiveness of conventional monetary policy.” But in this case we are talking about banks depositing liquidity with the ECB. Financial fragmentation among Eurozone countries has decreased over the last years but relevant target 2 imbalances are still present between core countries on one side and periphery countries on the other. Just to provide the reader with a few numbers on these imbalances, in December Germany was still running a surplus of € 461 bn, Netherlands € 19 bn and Finland € 15 bn. On the other side, Spain was showing a € 190 bn liability, close to Italy’s € 209 bn, while Portugal, Greece and Ireland were running a cumulated € 139 bn liability. A look at banks’ usage of deposit & current account facilities at the ECB by countries, sees German banks dominating the picture, with € 90 bn vs a much lower liquidity volumes ranging between € 10 bn and 15 bn for Italian, Spanish, Belgian, Austrian and Finnish banks. Banks belonging to core countries still hold a cumulated € 130 bn with the ECB, while periphery banks just hold € 35 bn overall. Negative rates contributed to a gradual fall in excess liquidity mainly kept by core banks at the ECB, but at the same time opened the way for bond yields to fall too below zero. Banks may have regulatory or other reasons to prefer bonds to ECB liquidity at -20 b.p. , but banks are not the only investors in core sovereign bonds!

Who are the holders of EZ sovereign bonds and will they sell their holdings to the ECB?

As net supply of sovereign debt won’t probably be enough to cover for ECB buying volumes and keeping in mind that the central bank will limit its purchases to a maximum 25% of outstanding debt for each issue, QE is likely to need investors’ sales in order to be fulfilled.

A look at holders of core and periphery government bonds sees some relevant differences: core sovereign bonds are held mainly by non-domestic investors, while the opposite is true for Italian and Spanish bonds representing periphery countries. Respectively around three quarters and two thirds of German bunds and French OATs are held by foreign investors. European insurers and foreign institutions play quite a role in both markets, as these instruments are high quality bonds much needed for different purposes which may have to do with regulatory reasons, liquidity reasons or because they are attractive for EUR denominated reserve management. On the contrary, around two thirds of Italian and Spanish bonds are held by domestic investors and the remaining third by foreign investors. The different risk/reward profile with respect to core govies makes for a much lower presence of official institutions, non-domestic insurance companies and foreign banks among investors in BTPs and Bonos. At the same time, the role of mutual funds and global asset managers appears quite relevant among non-Italian and non-Spanish investors.

The role played of Eurozone banks on the sovereign bond market is huge, as they hold 25% of the Eurozone general government bonds. Spanish banks hold 36% of the Spanish general government bonds while this percentage is 23% in Italy (Italian banks hold more than €430 bn of BTPs!) and only 16% in Germany and 11% in France. The banks’ holdings of Eurozone non-domestic sovereign bonds, that dropped in 2010/2011, has increased progressively over the last years, with a concentration on German and Italian bonds. EZ banks’ growing ownership of bonds has been partly driven, mainly in periphery countries, by deleveraging, carry trade and the recapitalization process. Some of these factors are easing to some extent, as loan demand is finally improving (this is one of the explicit aim of the ECB), carry trade is less and less profitable and most of the re capitalization process has already been implemented. However, loan recovery and reverse deleveraging is likely to be only gradual. Furthermore, new regulatory rules to maintain liquid balance sheets (Liquidity Coverage Ratio, LCR, associated to the Basel III rules) limits potential reduction of high quality liquid assets. Globally, the situation should be very different for core countries and peripheral countries. The ECB is unlikely to face difficulties to buy Italian sovereign bonds as German and French banks hold BTPs in large quantities (more than € 100 bn together) and that these assets have a weak IG credit rating. The same reasoning holds for Spanish bonds: the European non-Spanish hold for € 100 bn of Spanish sovereign bonds. On the contrary, this will be more problematic for German sovereign bonds as many banks will continue to hold them as they are liquid and have an excellent credit rating…

Long term investors, mainly Eurozone insurers and pension funds, also play a very important role on the Eurozone sovereign bonds market as they hold more than 20% of the market. Regulation forces are likely to encourage them to invest in longer-dated fixed income assets to hedge the duration of their liabilities. Yield desert and fewer left yield oases are likely to keep long term investors from being strong net sellers of government bonds.

A more active participation of foreign rather than domestic investors in selling bonds to the ECB is therefore possible, the more valuation will get tighter with respect to other alternatives available in global fixed income markets and the more bond yields become negative. International portfolio managers might rebalance their portfolios by selling Eurozone bonds to invest in Eurozone equities and/or in other zones. This being said, foreign investors domestically facing similar low yield environments, as in Japan, may keep their demand for EUR fixed instruments alive and reserve managers are another category of investors which will probably keep most of their current holdings.

Conclusion

Over the last months market players have increasingly anticipated ECB QE: therefore it’s right to affirm that bond prices already imply a large part of ECB future purchases. At the same time, the size of intervention relative to net supply likely to be available, the 25% outstanding limit by issue and the negative rates on banks’ liquidity facilities at the ECB are all factors which open to a further bull flattening of periphery and corporate bond curves over the next quarters. The search for yield and spread will even more drive investors’ decisions among Euro fixed income sectors. In a nutshell, the ECB’s QE is changing the nature of the European fixed-income market as one side, there is one big player ready to buy all the available bonds and as on the other side, there are many players not necessarily ready to sell easily, in particular because of regulatory constraints for banks and insurance companies. The struggle to find German bonds will intensify as the QE implementation proceeds and the theme of liquidity will matter even more on the fixed-income markets.