Last Wednesday, Mario Draghi and ECB chief economist Peter Praet had a clear message for critics of PSPP: we’ll keep printing money forever if we have to, but in the end, this is going to work. As skepticism grows regarding not only the soundness of the philosophy that underpins QE, but about whether the structure of the ECB’s asset purchase program is even viable, the central bank remains defiant to the end and indeed Praet doubled down on the rhetoric last week, noting that the ECB would “use all tools available” to ensure that “monetary dominance prevails.”
That kind of language may be good for morale in some circles, but a growing number of critics are suggesting that perhaps the world would be better off in terms of financial stability if the powers behind “monetary dominance” would let the market prevail for once so that some semblance of price discovery could begin to reassert itself. We’re a long way from that though and in fact, the outlook for euro money markets is anything but normal as Barclays made very clear last week. Here is our summary [13] of their take on the market:
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)...
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.
Meanwhile, the bund curve has a date with outright flatness and the ECB, by driving yields on even half-decent credits negative, is setting itself up to onboard hundreds of billions in negative yielding assets onto its balance sheet, guaranteeing a loss if held to maturity and we won’t even begin to speculate on what the paper losses will look like on a trillion euro portfolio of bonds purchased at 124% of par if either the central bank loses control of the narrative or some tail event (like a Grexit, or a Podemos-inspired Spexit) triggers a repricing of periphery risk.
In sum: the world’s central banks are playing a trillion dollar/euro/yen/soon-to-be-yuan game of poker where every player at the table is pot committed and has no choice but to go all in.
If you want to understand just how precarious the situation is, just ask Greek FinMin Yanis Varoufakis, a man who knows something about how to create and aggravate precarious situations:
“I find it hard to understand how the broadening of the monetary base in our fragmented and fragmenting monetary union will transform itself into a substantial increase in productive investments. The result of this is going to be an equity run boost that will prove unsustainable.”
The irony there is that Greece could definitely use some help in the way of outside demand for its sovereign debt and by criticizing QE, the FinMin is essentially shooting himself in the foot. Varoufakis — apparently not wanting to ruin his newly minted image as a man who is loving life right now — did note that he wasn’t trying play the role of the “party pooper” (he actually said that). We, however, will play that role by pointing out that Varoufakis is exactly right when it comes to runaway QE producing unsustainable equity rallies [14] as evidenced by the following:
Since 2010, The Bank of Japan has 'openly' - no conspiracy theory here - been a buyer of Japanese stock ETFs. Their bravado increased as the years passed and Abe pressured them from their independence to 'show' that his policies were working to the point that in September 2014, The BoJ bought a record amount of Japanese stock ETFs taking its holdings to over 1.5% of the entire market cap, surpassing Nippon Life as the largest individual holder of Japanese stocks. However, as WSJ reports, The BoJ has now gone full intervention-tard - buying Japanese stocks on 76% of the days when the market opened lower.
It’s so simple and obvious, even a Greek FinMin can figure it out.
And so can the Financial Times, where columnists are beginning to write about ECB asset purchases with a not-imperceptible hint of disdain [15] in their voices:
The advent of negative yields for the best European government or corporate issuers is usually reported in the media as some sort of curiosity, like a bright object in the night sky that seems to be getting bigger. What it really represents is the breakdown of the policy world’s response to the global financial crisis.
A large European bank’s credit strategist told me: “We have searched through the records, and asked the ECB how they think their (asset purchase strategy) will work, and there is no evidence they know the answer.
“From a cycle perspective, the time for the ECB to carry out QE was back when asset prices were too distorted and low. But credit spreads are already low. They are chasing investors into markets that will create a problem when markets normalise. It is just perverse.”
The fiduciaries’ hunger for yield on respectable assets has also run into the requirements for banks and other market participants to put up more high quality collateral for derivatives transactions. Jeremy Stein of Harvard, when he was still a Federal Reserve governor, addressed this issue in February 2013.
Mr Stein referred to how institutions short of high quality collateral required by reform-mandated clearinghouses might get the high quality stuff by swapping, or “transforming” it, with low quality paper. As he said in the paper, these collateral transformations “reproduce some of the same unwind risks that would exist had the clearinghouse lowered its own collateral standards in the first place”, and these transactions “create additional counterparty exposures (among the market participants).”
I asked around how the Fed had followed up on Dr Stein’s curiosity about these unintended risks to the clearing and settling plumbing of the post-reform system and found that while there was some interest there was not enough systematic data gathering or dynamic modelling. For all the Fed knows, the plane is being held together by spit and baling wire.
Speaking of anecdotal, it appears that the ECB is not able to buy the European sovereigns and first class bonds it wants at the rate of purchase it intended. Instead of €50m or €100m bonds at a time, its dealers are being filled at a fraction of those levels in each buying round. Nobody wants to sell an earning asset. What will replace it?
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Someone call the ECB because it looks like the game is well nigh up. Greek FinMins are taking time away from photo shoots [16] and looting pension funds to call out QE for creating equity bubbles and the mainstream financial news media has figured out that there’s an acute collateral shortage and that buying €1.1 trillion in bonds €15 million at a time probably indicates a forced deviation from the original plan.
With lackluster economic growth, disinflation, and exploding central bank balance sheets now a staple across the developed world, we think it’s time someone tells the central banks of the world what Dorothy told Oz:
“If you were really great and powerful you’d keep your promises.”
