Over the past two years, we have repeatedly cautioned that the biggest challenge facing the ECB as it expands its bond monetization is the ability to find sellers of private securities, i.e., a shortage of monetizable bonds, both government and now corporate. Last March, even JPM warned that it doubts the Eurosystem can "meet its quantitative target without distorting market liquidity and price discovery." That however has not stopped Mario Draghi from steadfastly continuing the ECB's QE, even as the bond shortage has gotten more acute by the week. In fact, according to Jefferies analysts, the shortage is now so profound that the ECB is effectively buying back bonds from itself.
According to a note by Marchel Alexandrovich and David Owen, first flagged by the WSJ, courtesy of the circular nature of the Eurosystem, the central bank has masked what is essentially a backdoor monetization of its own securities.
How does Draghi achieve this? As the WSJ notes, the ECB’s QE program is implemented through several national central banks, like Germany’s Bundesbank and Spain’s Banco de Espana. National central banks buy bonds according to rules set by the ECB. The problem is that these constraints narrow the stock of debt the banks can buy from. These rules prevent the purchase of too much debt from any one country and stop central banks from buying debt with steeply negative yields. Portuguese and Irish debt, for instance, is now becoming scarce. But the national central banks also sell sovereign bonds. They sometimes reduce their holdings as a part of their reserve management activities, which aim to ensure that banks, state institutions and other organizations “manage their euro-denominated reserve assets comprehensively, efficiently, and in a safe, confidential and reliable environment,” according to the ECB’s website.
As a result, while the German Bundesbank bought €209 billion in sovereign bonds between March and July, it also sold off €43 billion of such debt, according to Jefferies. Those securities are then back on the market to be bought, potentially helping the central banks to work around the program’s restrictions.
The conclusion: “This suggests that one of the ways that QE has been implemented, especially in the countries where scarcity may be an issue, is that the (National Central Bank) is essentially buying bonds from itself; or more intriguingly, perhaps even from the other NCBs in the Eurosystem,” said Mr. Alexandrovich, one of the economists.
Circular nature of the ECB's bond monetization notwithstanding, it merely confirms the underlying problem: there are simply not enough government bonds for the ECB to keep buying, effectively putting a hard limit on how long Draghi can continue his QE program.
There is, however, one loophole, one which the BOJ exploited recently when instead of expanding its bond purchases, it launched an even more aggressive equity buying spree, by doubling the amount of ETFs the central bank would buy.
That, according to Reuters, is precisely what will happen next, as it writes that the ECB may soon be forced to follow the Bank of Japan's example and buy equities as part of any expanded stimulus programme. Reuters then recaps the familiar problem: "The European Central Bank could run out of eligible bonds for its 1.7 trillion euro bond-buying scheme, meaning alternative options are on the table should it decide to loosen policy further to lift growth and inflation across the bloc. Analysts say these could include large-scale share buying, a policy that the BOJ has already adopted after it started purchasing equity exchange traded funds (ETFs) for its own quantitative easing scheme six years ago."
As Kuroda will readily admit, ETFs offer an easy way to directly monetize, and nationalize, the stock market:
"ETFs allow an investor to trade a range of assets, from a basket of stocks to government debt. ETFs, which offer a convenient way to purchase a broad basket of securities in a single transaction from an exchange, have risen in popularity with investors due to their simplicity and lower fees."
However, the ECB faces significant hurdles in helping all 19 euro zone members equally without distorting a key market for investors. According to Reuters, buying ETFs in the 19-nation euro zone would be far from simple for the ECB, both practically and politically. "How do you buy an index which favours all countries within the euro zone? Obviously the ECB doesn't want to be seen favouring one market above another," said Commerzbank economist Peter Dixon.
The answer is, "you don't", so you do whatever Mario Draghi's former employer, Goldman, advises him to do.
Putting Europe's ETF market in context, investments in Europe-listed ETFs are worth just over $500 billion, compared with nearly $200 billion in Japan and more than $2 trillion in the United States, according to consultancy firm ETFGI.
And while, the European ETF market is bigger than Japan's, such a scheme would have to benefit 19 member states, from heavyweight Germany to tiny Slovakia. If it buys an ETF that tracks a pan-European stock index such as the Euro STOXX 50 or MSCI's EMU index , which are weighted in terms of market capitalisations, the ECB runs the risks of being seen to favour only the bloc's biggest economies or sectors.
Alternatively, the ECB may simply throttle liquidity even more, if - for example - it bought single-country ETFs, which would result in liquidity issues since the ETF market is still developing.
Continuing its analysis of which ETFs the ECB would buy, Reuters notes that of the top 10 firms listed by market cap in the MSCI EMU stock index, four are French, three are German, with the rest listed in Belgium, Spain and the Netherlands.
The BOJ's foray into equity buying highlights potential pitfalls. While the BOJ does not reveal details of its buying, analysts say it disproportionately benefits a handful of high-priced shares that have outsized weightings in the Nikkei stock average. The ECB has been careful to limit its asset buying in a way which follows some orderly distribution across the region. Under its government bond-buying scheme, the ECB buys bonds in relation to a country's contribution to the bank - although it has deviated from this already in purchases of corporate bonds.
"As with the current bond buying programme, the capital key would certainly be an issue they have to think about," said Antoine Lesné, EMEA head of ETF strategy at SPDR ETFs, part of State Street Global Advisors. "This would determine the choice of the index and/or the strategy. Then one would need to look at the current product availability. This would also skew the impact on the larger contributors to the euro zone economy which may need less of that support compared with those of the periphery for example."
Most troubling about the Reuters piece, however, is that it is phrased in a way as if the ECB's ETF purchases were already a done deal, and all it needed was a way to prepare the market. To wit:
There are many options available to the ECB before it chooses to buy ETFs and tweaking the parameters of its current bond-buying programme would also ease pressure on the central bank to follow more radical measures such as stock purchases.
However, even Reuters admits that because of the complexity and because stock investments are not as prevalent in Europe as in the United States, there may be fewer benefits from such a plan than from other options. Asked in May whether the ECB would contemplate buying equities, its vice president Vitor Constancio said only that no further measures would be adopted so soon after policy was eased in March. At least two ETF providers contacted by Reuters said they had not been in any discussions with the ECB.
As Thomas Bartolacci, head of ETF Capital Markets at Vanguard, the second-biggest provider of ETFs in the world after BlackRock said "Equities are fraught with more questions and that would make buying by any central bank a little more difficult of a pill to swallow." That said, Vanguard and BlackRock would both be delighted if the ECB did in fact launch monetization of stocks by way of ETFs as it would lead to even greater demand for passive investments (which Vanguard would gladly provide), while at the same time frontrunning the ECB would send the European market to record highs, spilling over across the world.
Sadly, what is not discussed is that as CLSA concluded one week ago when looking at the BOJ's ETF purchases, it said that the "BOJ is nationalizing the stock market" because that is precisely what it is doing with every incremental intervention in the stock market.
"If it seems strange that the BOJ is hamstringing the price discovery mechanism of the Japanese stock market by partially nationalizing it, it is all the stranger that it chooses to do so by substantially skewing its buying towards such a distorting index. The arbitrary decisions of the Nikkei committee get to choose the destination of trillions of yen of BOJ – and hence government - money."
Alas, this latest Reuters "trial balloon" points to just one direction: despite the political complexities, the ECB will soon have no choice but to start monetizing ETFs, and perhaps an outright basket of stocks, as the European stock market follows Japan in the "nationalization" route. And why not: after all the bond market has already been nationalized in both Japan and Europe, with the ECB explicitly providing the funding for merger transactions. Considering that the true mandate of all central banks has always been the "wealth effect" and pushing risk assets higher, why stop there?
Finally, once the ECB and BOJ (not to mention the SNB of course) are both monetizing ETFs, how long before the US Federal Reserve will be forced to join in, and the global nationalization of all stocks markets is complete?