The ECB’s PSPP got off to a rather inauspicious start on Monday when the central bank admitted that the governing council “hasn’t agreed on how to treat losses” on bonds with negative yields. Clearly this is a problem given that: 1) quite a bit of core, shorter-dated paper already trades in negative territory, and 2) the purchases themselves will drive down yields across the board in what will quickly become a self-fulfilling prophecy. The only hint given as to how the ECB and NCBs intend to tackle the issue was this: “National central banks might try to avoid buying such securities for now.”
Then we learned that DOMO trades were going through in increments of between €15 and €50 million suggesting that a general lack of supply and/or liquidity may well stymy the entire enterprise. On that point, we said the following:
Needless to say, if the ECB is unable to meet its monthly asset purchase targets (which, at €15-50 million dribs and drabs, looks likely), expect chaos, as the market has spent the last several months front running PSPP and would be absolutely horrified if DOMO (Draghi-open-market-operations) has to be downsized.
On day two of PSPP the news continued to reinforce both the idea that “avoiding” negative-yielding assets will be quite difficult given the program’s scope and, relatedly, sourcing enough bonds to meet monthly targets is going to prove exceptionally difficult in some markets.
As for trying to avoid negative-yielding assets, it appears as though that effort lasted all of 24 hours. Here’s Bloomberg:
- Central banks said to buy German notes that have negative yields
- Central banks purchased 5Y securities, said three people with knowledge of the trades, who asked not to be identified because the transactions are confidential
In terms of sourcing enough purchasable bonds, Citi notes that if, in a pinch, the ECB expanded the issue cap all the way up to 50% (from 25%) in non-CAC bonds (NCBs can’t do this with paper that contains CAC clauses without obtaining a blocking minority), the central bank could add an additional €500 billion to the program:
However, Citi goes on to say that even with that option and even if the ECB adds other agencies to the list of eligible debt, core countries may still fall short of their targets resulting in “effective tapering”:
The third, and final concern on QE execution is that despite the agency and non-CAC bond options, some core NCBs may not be able to fulfill their QE quota. In that instance, we see the following evolution of events:
The core NCB quota is moved to the semi-core/periphery to prevent the effective tapering of QE. This is made more practical buy the localization of risks.
If that proves too controversial, perhaps with an eye on the German constitutional Court, then the ECB could move to cutting the depo rate further to maintain loose financial conditions and especially to prevent a taper tantram forcing EURUSD higher.
There are several interesting things to note there. First, only two days into DOMO and there’s already talk of a taper tantrum triggered by the core’s inability to source enough bonds to meet quotas (everyone saw this coming of course, including us). Second, as we noted last week, it does indeed look as though the ECB will have to cut rates further into negative territory — recall that JPMorgan thinks we’re headed all the way down to minus 3%.
The punchline to the whole thing is this: even though PSPP is so large that it literally cannot be implemented fully given supply constraints, in the new paranormal where QE programs are measured in terms of how large they are relative to a country’s GDP, the ECB’s effort here is just not enough to appease the market. From Citi:
...the size of the programme is small in terms of what is needed to achieve the stated objective of increasing medium-term inflation of “below but close to 2%”, especially when compared to the size of QE in other markets.