Experiments, by their very nature, tend to have unintended consequences and on the eve of Q€, it appears as though the ECB’s previous policy decisions may have caused the central bank to unwittingly paint itself into a corner. Having pledged to purchase some €1 trillion in assets over the next 18 or so months, Mario Draghi now faces the rather perplexing logistical challenge of finding enough bonds to buy. What’s obvious from the following tables is that convincing domestic banks, insurers, and pension funds to sell is particularly important but will, for reasons outlined below, likely prove well nigh impossible.
As discussed previously, the ECB’s predicament (i.e. the reason it’s looking for sellers) is the result of a supply shortage. Fixed income net issuance across the Eurozone has only averaged around €340 billion over the last four years, meaning supply can’t possibly keep up with the ECB’s demand. In fact, at the individual country level net supply less-Q€ will be negative for Germany, France, Italy, Belgium, Netherlands, Austria, Finland, Portugal, and Greece in 2015. Put simply: someone, somewhere has to be willing to sell in order for the bank to have any hope of executing its plan
The problem, as several sources told Reuters last week, is that there simply aren’t a lot of willing sellers. Ironically, the ECB’s own policy maneuvers are ultimately responsible for creating this situation. That is, the fallout from previous forays into ultra accommodative monetary policy is now hampering the implementation of quantitative easing - call it the ultimate easy money paradox.
For instance, last September, the ECB cut its deposit facility rate to -0.2% in an effort to fight low inflation and encourage banks to put capital to work. Of course, this effectively eliminated one option for where prospective sellers might choose to park their proceeds should they decide to unload their EGBs to the ECB. That is, if I’m a bank, I’m not going to be too thrilled about the prospect of selling an interest-bearing asset only to turn right around and pay 20 bps for the right to hand the cash I just received right back to the buyer. The ultimate irony here is that, as mentioned above, the deposit facility rate cut was meant to counter disinflation, as is Q€. So what we’re witnessing is one deflation-fighting policy stymying another.
Another problem for the ECB is that sellers of EGBs expose themselves to the very real possibility that proceeds will have to be reinvested at lower rates. For some EGB holders, like insurers, this prospect simply isn’t feasible from a regulatory perspective. Here’s Morgan Stanley:
The biggest holders, Eurozone banks and insurers, will be reluctant sellers, given it will mean reinvesting at lower yields. If the ECB responds by pushing yields lower in an attempt to incentivise sellers, this could have an opposite effect, as lower yields could actually deter banks and insurers from selling.
Regular harvesting of unrealised gains, undertaken in part to meet life policyholder obligations, is expected to continue and may be a source of limited supply [but] our base case is that insurers will not seek to take advantage of the ECB bid and sell bonds in size, given their overriding priority to ensure as strong as possible matching of assets and technical liabilities.
As for banks, selling to the ECB would likely have the effect of compressing NIM, exacerbating the negative effect QE already has on margins. Domestic banks are unlikely to volunteer for something that will squeeze them further when they’re already concerned about the effect ECB asset purchases will have on their bottom line. Just ask Deutsche Bank’s Anshu Jain who, less than 24 hours before Draghi’s January presser, had the following to say about Q€:
“...it means very low interest rates and a real destruction of net interest margins, which of course will be a huge challenge. So the best parts of our businesses, the deposit taking and the flow franchise businesses will all suffer."
To drive the point home, here’s Morgan Stanley on why domestic banks won’t sell:
Eurozone banks own ~one-fifth of Eurozone debt (more in the south than north).
We suspect banks will be reluctant to sell because this would reduce NIMs and loan demand is yet to recover. The ongoing deleveraging in Europe may diminish banks’ capacity to sell bonds as deposit growth may continue to outpace loans.
Again we see existing easy money policies restricting the effectiveness of new easy money policies, or more accurately, the central bank’s previous efforts to drive down rates are thwarting its current plans to … drive down rates. This may well be the ultimate Keynesian boondoggle.
At the end of the day, it appears as though the ECB may need to turn its gaze outward:
We think Global asset managers have the ability to sell tactically, and may look to do so, given rich euro valuations vs. other sovereign markets. Global fixed income asset managers benchmarked to market-weighted indices have a large benchmark exposure to euro sovereigns (31% of their index), but generally have discretion to diverge from these benchmarks. As a result, they have the ability to tactically reduce their euro sovereign exposure if they think EGBs are likely to underperform other global government bonds. Syndication data show non-domestic investors, primarily asset managers, were significant buyers of euro sovereign paper in 2014, much of which we think was reducing previous underweight positions. However, we think they could be significant sellers to the ECB, given the richness of euro sovs cross market.
To summarize, the ECB will have to turn to foreign holders (who, as a reminder, ran the other direction during the height of the Eurozone crisis at the first mention of a periphery government bond) and, in yet another irony of ironies, the central bank may find some sellers there precisely because CB policy has created unsustainably rich valuations in € credit.