It was almost three years ago to the day when Zero Hedge first explained the biggest problem facing Europe when it comes to unconventional monetary policy: the lack, not scarcity, but outright shortage of collateral.
Initially, our focus was on private-sector collateral, and if one had to summarize the key difference between the US and Europe in one chart, it would be this one, showing that while in the US the split between secured and unsecured funding was roughly even, in Europe, some 90% of corporate funding was on bank loan books, with only 10% in the form of (unsecured) corporate bonds (which also explains why in Europe NPLs, aka bad bank debt is by far the biggest problem facing the financial industry).
Subsequently, we also showed that the collateral shortage is not only in the private bond market, but in the public one as well, because there simply wouldn't be enough net supply in Europe to cover the ECB's ambitious demands.
Three years later, and following the first week of direct ECB monetization in the bond market, we have proof not only that our warnings were accurate, but that the worst case outcome for the ECB - a failure to achieve its stated goals is now only a matter of time. The reason? After just a few days of intervention, the ECB's grand monetization experiment has already managed to get derailed.
To avoid repeating ourselves yet again, here is JPM with the full explanation of how the ECB appears to have broken the already rickety European bond market.
First, there is the issue of collapsing market liquidity as manifested by the plunge in European bond market depth to near record lows. Quote JPM:
The price action over the past few weeks and the market impact that the ECB purchases (of €9.8bn in three days) had in the first week of its QE program are raising concerns about collateral shortage and about whether the ECB will be practically able to achieve its bond purchase target without impairing market liquidity and the price transmission mechanism (i.e. without violating what the ECB defined as market neutrality condition).
The first issue of collateral shortage can be seen in the collapse of GC repo rates to negative territory since the beginning of last week for terms of greater than 3 months. 1yr Germany has been trading at close to -30bp; i.e. one can currently fund purchases of Bunds via the term repo market and achieve positive carry by even buying Bunds with yields between -20bp to -30bp. We note that this expensiveness in term repos shows how unwilling Bund holders are to depart from their collateral for more than a few days or weeks.
The second issue of market liquidity distortions is exacerbated by two developments, in our view:
1) by the big increase over the past two weeks in the universe of euro government bonds between 2y and 30y remaining maturity trading with a yield below -20bp. Figure 1 shows that this universe spiked to €170bn at the beginning of this week driven by Bunds. This means that almost 4% of the €4.6tr universe of 2y-30y euro government bonds and more than 20% of the €800bn universe of 2y-30y German government bonds traded below -20bp earlier this week, effectively inducing the ECB to extend the duration of its purchases.
2) by the sharp decrease in Bund liquidity as our market depth metric; i.e. the ability to transact in size without impacting market prices too much, collapsed this week (Figure 2). We measure market depth by averaging the size of the three best bids and offers each day for key markets. Figure 2 shows two such measures, for 10-year cash Treasuries (market depth measured in $mn) and German Bund futures (market depth measured in number of contracts). While both UST and Bund market depth have been trending lower in recent months and while the former moved recently below the Oct 15th low, what was striking this week was the divergence between a modest increase in UST market depth vs. an abrupt decline in Bund market depth. We note this development effectively challenges the market neutrality condition of the ECB from the first week of purchases already!
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And then there is the just as critical issue of collateral scarcity.
But before we get into this point, we urge readers to refamiliarize themselves with the critical topic of shadow banking collateral volecity by rereading "What Shadow Banking Can Tell Us About The Fed's "Exit-Path" Dead End", since this is i) all that matters in a world in which every asset move is based on leverage of derivatives and in which the underlying collateral is so scarce, what matters is how efficiently its (re-)rehypothecated asset manifestation is re-used and ii) since virtually nobody actually understands this critical concept.
To be sure, our 2013 article was looking at the Fed's "exit" pathway, one which will soon be all the more critical if indeed Yellen is hoping to not only hike rates soon but to actively unwind the trillions in excess reserves. This is what Peter Stella wrote a year and a half ago on this topic:
Many major central banks are thinking strategically about exit pathways – how best to return to normal central banking. The main point of this column is to point to a key issue – the role of collateral – that has been under appreciated by many economists who are not in daily contact with financial markets.
When economies strengthen and central banks begin to drain reserves from the system, they will inevitably alter the composition of private sector asset portfolios.
- If good collateral is swapped for reserves, banks and nonbanks can use the collateral to fund create credition via what are known as collateral chains.
- If only term deposits are swapped for reserves, or if interest rates are raised only through IOR, the opportunity to lengthen collateral chains will be missed.
In today’s financial world, these chains are critical sources of money and credit creation – the days of textbook money-multipliers are long gone.
When it comes to reducing excess reserves, the ‘how’ matters as much as the ‘when’ and ‘how much’. Understanding this point requires mastery of the brave new world of shadow banks and re-hypothecation – a world that either did not exist or was truly in the shadows when most of us were taught about money and credit creation.
Stella's article also touched on something even more critical and even more misunderstood, namely why in a world in which rehypothecation, and shadow banking dominates, QE is in fact deflationary:
There is a great irony in the journalistic history of monetary policy. What many are calling central bank “money creation” “helicopter money” or “rolling the printing presses” may – in combination with tighter leverage ratios – lead to a tightening of bank credit and deflationary pressures. And all this is occurring while the spectre of uncontrolled credit expansion and monetary debasement are being decried countless times by those who have not recognized that yesteryear’s monetary paradigm is defunct.
... those such as the Fed and the ECB, who will keep piling on failed monetarist theories, in the process deflation the system even more (and pushing trillions and trillions of excess reserves into the equity markets, resulting in hyperinflation in risk prices and deflation everywhere else), until finally one day the central banks have no choice but to unleash hyperinflation. How? Well, rereading Ben Bernanke's seminal November 2002 "Deflation: Making Sure "It" Doesn't Happen Here" speech explains it all:
Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
Said "helicopter drop" is coming, as is the hyperinflation it will engender via the inevitable collapse of fiat, but not quite yet: first the ECB, and then the PBOC, will jump through hoops and go through the motions to once again confirm they never grasped just how "yesteryear's monetary paradigm" became defunct, and inject that many more trillions of de novo created money into risky assets, meanwhile exporting deflation to anyone who isn't easing (thus explaining the 25 or so rate cuts in just the past two and a half months).
Indicatively, this is how we summarized this paradox nearly two years ago:
The paradox is that for the Fed to finally start "fixing" the economy, instead of the brokerage accounts of a few billionaires, it has to finally stop QE, because as long as it is running, the only "inflationary" sink hole will be global risk markets, and the only thing levitating are all asset prices enveloped in this bubble.
The Fed may have eased off the throttle, but it was merely replaced with even more easing by the BOJ and now, by the ECB. In a fungible, globally interconnected world, it means that in 2015 central banks will inject more liquidity than ever before.
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Which brings us back to the topic of collateral shortage in Europe. And while the above section dealt with collateral shortage in the context of a monetary policy "exit", what JPM has done is flipped it around and shown just how profound are the limitations as the ECB tries to "enter" the same labyrinth of paradoxes that the Fed can supposedly exit in "15 minutes" (spoiler alert: it can't, and never will).
Back to JPM:
This week's speech by the ECB's Executive Board Member Benoît Coeuré tried to address both of the above issues. In particular the speech reinvigorated the debate about collateral shortage in the Euro area. Similar to his Oct 2012 speech, Coeuré made a distinction between collateral shortage and collateral scarcity "Scarcity is a fact and not a problem per se. Allocating scarce resources through prices is the way our economies work. The problem would be a shortage of collateral and/or an impaired price mechanism." At the time, in October 2012, the issue of collateral shortage arose because of the €2.5tr that was put forward as collateral by Euro area banks to be used in ECB's repo operations. We had argued at the time that those fears of collateral shortage were not justified as the ECB had in fact improved collateral availability. Via LTROs the ECB had created more than €1tr of reserves (i.e. cash) against low quality (e.g. peripheral and bank debt) or non marketable collateral (e.g. credit claims). Central bank reserves are equivalent to cash and represent highly-liquid high-quality collateral. In other words, the ECB had created at the time on net €1tr of additional high-quality (i.e. cash) collateral improving collateral availability.
However the situation is very different currently. It is true that in principle QE by itself does not affect the overall supply of collateral as government bonds are replaced with reserves; i.e. one form of high quality collateral is replaced by another form of high quality collateral. The only thing that is changing is the relative pricing of collateral. So in principle, the ECB's QE is merely creating scarcity by making one form of collateral (euro government bonds) more expensive relative to cash.
That's not all: the fungible reserves, because they can no longer be used by banks for downstream rehypothecation purposes, are instead used to invest in risky assets such as stocks. Unsure what this means? Then take one look at the mindblowing move in the Dax (or EuroStoxx) in the past 2 months since the announcement of Q€.
That's nothing more than frontrunning the ECB's reserves being fully allocated to risk assets instead of lying dormant in the form of European Government bonds.
Which then brings up the Stella point noted above regarding collateral rehypothecation front and center, because as JPM notes, "this assessment is complicated by reduced usage and efficiency of cash collateral in recent years. In particular, usage of government bond collateral has increased at the expense of cash collateral by both banks and investors. We note that buy-side investors are becoming more averse to usage of cash collateral for three reasons: 1) to avoid raising cash to meet margin calls by having to sell or repo assets from their portfolio thus increasing transaction costs; 2) to avoid the operational cost of processing interest payments back to the counterparty; and 3) to avoid becoming technically overweight cash which dampens returns, especially in the current zero or negative interest rate environment."
Banks are responding positively to reduced appetite for cash collateral by the buy side as this also helps banks to increase the efficiency of their own collateral management processes via re-hypothecation of security collateral and via consolidating and optimizing collateral across OTC derivatives, securities lending and repos to meet more onerous regulatory requirements. Re-hypothecation or re-use rate of security collateral has decreased post the Lehman crisis, but at around x2 currently it makes bond collateral more efficient than cash collateral."
Unsure what this means? Then refresh the following chart from 2013:
In all, different to 2012 when the ECB was replacing low quality collateral with higher quality collateral, the ECB is currently replacing high efficiency government bond collateral with lower efficiency cash collateral. In a way an argument can be made against Coeuré’s speech that the ECB not only creates scarcity of one form of collateral vs. another but that it also creates shortage of collateral by replacing high efficiency collateral with low efficiency collateral.
That would be 100% correct, and one can now merely add Coeure to the ranks of those who don't understand that "yesteryear’s monetary paradigm is defunct."
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Finally, it is not just the topic of swapping one asset with a higher collateral velocity for another with a far lower, if not zero, velocity, but also the issue of effective supply. As JPM notes, "another important aspect in Coeuré’s speech regarding market liquidity was the notion of "effective supply". What matters more for market liquidity and depth is indeed not the overall stock or supply of euro government bonds, but the size of the effective supply as some asset holders may not be willing to sell. And it is effective supply that would determine whether the Eurosystem be able to meet its quantitative targets. While it is inherently difficult to calculate effective supply we believe we can make some reasonable assumptions to proxy it."
But before JPM's analysis of effective supply in Europe (or lack thereof), it takes one more swipe at just how clueless the Goldman-advised ECB has become:
... we disagree with Coeuré’s view that, similar to their Japanese counterparts, "euro area banks will be more willing to sell euro government bonds to the ECB as they will receive central bank reserves, which in the current low interest rate environment can be viewed by banks as close substitutes for government bonds, and which count towards fulfilling e.g. the required liquidity ratios". The problem with this argument, in our view, is that the ratio of government bonds + reserves to assets for commercial banks remains low for European banks vs. those in the US or Japan. Euro area and UK banks, in particular, have a ratio of government bonds + reserves to assets of 7% vs. 30% for their US and Japanese counterparts. If Euro area banks sell no bonds at all to the ECB and at the same time the ECB injects €1.1tr into the Euro area banking system, the ratio of government bonds + reserves to assets would rise to 11%. This will still be well below the 30% for their US and Japanese counterparts. In addition, as we argued above, government bonds are worth more to banks from a collateral point of view given rehypothecation. And this is perhaps one of the reasons that banks are currently willing to hold euro government bonds with yields that are below -20bp. In all, we continue to believe that banks in the Euro area could end up selling bonds to the ECB, but to a much smaller extent than their Japanese counterparts given their much higher need for liquid assets.
Especially since the bulk of European bank "assets" are in the form of tens of trillions of "secured loans" which are turning "non-performing" at an alarming pace.
Which brings us to a most critical issue, and one which will be discussed in the coming months, potentially leading to the next European funding crisis - the ECB's stealthy attempts to incentivize the selling of government bonds by quietly moving them from "risk-free" to suggesting they do in fact have an implicit risk. The reason why the ECB is doing this is clear: it know very well that absnet a structural impetus to sell their bonds, European banks simply won't do that, as JPM correctly assumes. As a result, the ECB, and specifically ESRB, will likely soon "shock" the world when it reveals once again that far from having a zero-risk weighting, government bonds are in fact risky, and the logical thing for banks will be to sell them!
In addition, we find rather concerning the statement that "irrespective of the desirable review of the current regulatory framework of sovereign exposures, it is in the best interest of banks to reduce their exposure to their respective government, which should increase their willingness to sell." Clearly, euro area banks and investors are not factoring in a change in the risk weighting regime for government bonds in the foreseeable future. Coeuré’s speech coupled with the publication this week of an ESRB (European Systemic Risk Board) report arguing for increased risk weightings for sovereign bonds is concerning in our mind. Domestic banks have been stable holders of sovereign debt during the euro debt crisis and inducing a change of ownership to perhaps less stable holders, could risk making euro sovereign bond markets more vulnerable to future crisis.
And in a market in which the herd moves as one, and in which there is no liquidity (such as the European government bond market), all the ECB needs now is a controlled demolition whereby European banks, which ever since the infamous "whatever it takes" comment in July of 2012 suddenly decide to sell all their bond holdings. Even with the ECB as a backstop buyer, this essentially guarantees bond market chaos in the coming months.
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Going back to the issue of calculating effective supply JPM references a recent report, "Who will sell to the ECB?" in which it argued that the Euro area looks more like Japan in terms of net bond withdrawal, "so various bond investors will need to sell bonds to the ECB eventually as was the case in Japan."
We also argued that the most likely candidate sellers to the ECB are non-euro area investors but with limited contribution from reserve managers, domestic retail investors as they shift away from bonds towards equities and domestic non-bank financial institutions. By looking at the holdings of euro government bonds by these sectors, i.e. investments funds, non-euro area banks/pension funds/insurance companies and others (excl. reserve managers), we calculate that the effective supply of euro government bonds is roughly 30% of overall supply (of €4.6tr stock of 2y-30y euro government bonds) which is not much higher than the 17% share the ECB intends to buy by September 2016. I.e. on our calculations effective supply could be as low as 30% of overall supply.
Here the ECB's last ditch backstop will also prove shortsighted and lacking:
The ECB has the provision that "in case the envisaged amounts to be purchased in a jurisdiction cannot be attained, national central banks will conduct substitute purchases in bonds issued by international organisations and multilateral development banks located in the euro area. These purchases will be subsumed under the 12% allocation to international organisations and multilateral development banks, which will be purchased by some national central banks". While this provision gives some flexibility to the ECB, we note it risks transmitting liquidity impairment from one jurisdiction to another. Raising the issue limit to above 25% for certain bonds or cutting the depo rate to more negative territory are possible options by the ECB as mentioned by our fixed colleagues, G. Salford section in this week’s GFIMS. But again this only shifts the market liquidity problem from one bond segment to another and risks making the ECB chasing its own tail, in our view.
And here, dear readers, is JPM's conclusion - phrased as politely as possible - why the ECB will fail in its QE endeavor, something we have been warning about for the past three years: "In all, we note the above analysis challenges the ability of the Eurosystem to meet its quantitative target without distorting market liquidity and price discovery."
What happens then, just before the wheels of the entire "modern" financial system fall off as the credibility of the "western central bank model" is lost once and for all, is that said model will desperately look toward China, and pray to Beijing to allow the PBOC to join the global monetization intervention in one last ditch effort to preserve the current financial system, before the infamous money paradropping helicopters are finally put into play.
That too will fail, but it will buy the status quo a few more precious months to prepare for what comes after the systemic reset which even JPM, indirectly, warns is fast approaching.