Mario Draghi, Collateral Scarcity, And Why The ECB Will Soon Buy Corporate Bonds

While Mario Draghi was most certainly not the star of yesterday’s ECB presser, he did say something some pretty ridiculous things about bond scarcity. Here’s a rundown:


We guess there’s a certain extent to which talk of scarcity is a “little exaggerated” and/or “premature,” in the same kind of way in which talking about a shortage of Japanese ETFs in the context of BoJ purchases is a bit premature because the central bank doesn’t yet own them all. But just because you don’t yet own all of something doesn’t mean you are not making something scarce kind of like just because you can still get water out of the faucet in California doesn’t mean there’s not a drought, and if one key indicator of scarcity in credit markets is the degree to which certain issues trade special then Draghi is either ignoring the “evidence” or he doesn’t know what evidence of scarcity looks like. In fact, as we showed on numerous occasions last month, bund market depth was impaired within a week of PSPP’s inception and as HSBC noted earlier today, there’s a certain element of common sense here that seems to have escaped Draghi:

Via Bloomberg:

“Strange” that ECB doesn’t see evidence of collateral shortage when German general collateral rates are near record lows, Subhrajit Banerjee, strategist at HSBC, writes in client note.


1Y repo rate for bunds is close to -32bps, inversion of GC curve is at extreme level


Academic studies suggest inversion of GC curves gives strong signal that bulk of securities are likely to trade special in near term

Similarly, here’s JPM from last month:

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. 

And here’s Barclays:

Furthermore, we do not expect the Eurosystem’s securities lending to limit the richening of the GC rates that is largely driven by supply/demand imbalances. We believe that strong demand for high-quality collateral induced by regulation (also preferred to cash, which is charged at a negative rate) and aggressive buying by the ECB in the context of low net supply of bonds should push core GC rates well below the deposit facility rate, which in our view will not be a floor for rates. Therefore, we see still room for a further richening of core GC rates as well as front-end yields both outright and versus Eonia.


So yes, there is indeed evidence of scarcity, but if one doesn’t want to make the leap of logic that it takes to posit a connection between GC rates and scarcity, one could also do something like this: look at the country which everyone says will have to most trouble hitting its monthly purchase targets (Germany), add up what there is to buy, construct a few alternative scenarios to account for the fact that core spreads may tighten and push a portion of the remaining purchase-eligible bonds below the depo rate thus rendering them unpurchasable, then just see if these assets are in fact getting scarce.

Fortunately, Morgan Stanley did just that and discovered that “if yields continue to fall, it will be impossible for the Bundesbank to purchase all the bonds planned.” So if what Draghi means by “evidence” of “scarcity” is indisputable proof that given the program’s current setup, Jens Weidmann can’t possibly hit Germany’s targets because there simply aren’t enough eligible bonds to buy, then it would appear that the following table is something the ECB should look into:

Despite this, MS is careful to adopt a central planner-friendly, neutral (if completely contradictory) stance on the issue:

The ECB could credibly argue it sees no signs of scarcity weighing on the market yet, while at the same time the eligible pool of bonds available for purchase looks dauntingly small given the scale of purchases planned. 

So basically, one can “credibly” argue that something isn’t scarce even if, in the very same sentence, one also says that the supply of this thing that isn’t scarce “looks dauntingly small.” Got it. 

If that wasn’t enough sell-sider doublespeak for you, try this:

Something Will Have To Give. But the resolution of the Phoney War may not be very dramatic, with either the ECB loosening its PSPP constraints, or the market becoming less concerned about the potential collateral squeeze. President Draghi was somewhat dismissive of the collateral squeeze/scarcity argument, given that cash can generally be used as a substitute for bonds for liquidity or collateral purposes. There was no indication, though, that the Depo rate would be raised to make cash a more attractive alternative for banks. There was an expansion of the list of SSAs eligible for purchase, but this expanded the purchasing universe by a mere €92bn and crucially did not involve adding any German agencies (see Exhibit 4) and hence does not relieve concerns about the scarcity of Bunds. 

So “something will have to give,” which sounds ominous until you get to the next sentence where you learn that when something does finally "give", it won’t be “very dramatic” because the market is going to become “less concerned,” which will have you relieved until you get to the last sentence where you learn that the expansion of the purchasable SSA universe is insignificant and should do nothing to relieve your concerns about scarce Bunds that really aren’t scarce. 

Furthermore, this: “given that cash can generally be used as a substitute for bonds for liquidity or collateral purposes,” isn’t really true, because as we’ve outlined previously, cash is inefficient as collateral (think reuse) and so QE replaces efficient collateral (bonds) with less efficient collateral (cash) and the real punchline there is that in the guidelines for the PSPP securities lending program, the very first condition is “cash neutrality,” so both figuratively and literally speaking, cash is not a substitute and the ECB clearly knows this because they wrote it into their own securities lending rules. Recall what JPM said about this: “cash neutrality” means that there will be no exchange of cash for collateral but only an exchange of collateral for collateral. As expected, the ECB seems unwilling to appear to be altering the overall amount of liquidity by “draining” reserves in cash for collateral exchanges.”

Finally, SocGen is out with a note which some folks at FT think “seems relevant.” Why yes, it does "seem relevant" doesn't it? That's because what this note says is that the ECB may soon be forced to chart a course for Kuroda crazy land. 

The concept is pretty simple: no one wants to loan money to a company at a negative interest rate (although they’ll do it for a recently insolvent sovereign) and so the further into negative territory you push the risk-free rate, the wider the spread to corporate credit. This, SocGen says, may force the ECB to purchase corporate bonds which will have the happy consequence of checking two Keynesian insanity boxes at once. Further imperil the central bank balance sheet? Check. Strip whatever’s left of the market’s ability to signal anything about credit risk by sending yields below zero for assets which are by their very definition not risk free and thus contribute to the growing number of NIRP-inspired aberrations? Check.

Via SocGen:

How will this impact credit spreads? The most likely answer is – more of the same, meaning that low-grade bonds will do better than high-grade issues. In “What European credit investors can learn from Capybaras,” we explained why falling government bond yields create a problem for high-grade corporates. Credit investors don’t want to buy corporate bonds at yields of less than zero. If the yields on the government benchmarks against which these bonds are priced continues to fall, as our rate strategists expect, and if corporate yields stop falling at a lower limit of zero, then the spread between the corporate bond and benchmark bond yield will have to widen…


...we are beginning to think that the ECB might have to buy corporate bonds after all – though not for the reasons discussed by our rates team. The lower limit problem (which we discussed most recently in “What the ECB did to credit in March, and what it will do in Q2”) may end up leading to some fundamental mispricing of credit risk, which the ECB might need to right by buying corporate bonds…


But making the cost of credit for AA and A companies is not the goal of the ECB. Far from it. If the lower limit problem keeps driving up spreads in this area of the curve, then the ECB might well be forced into the market, to drive down spreads on high quality credit. Corporate bond yields could then go negative – just as government yields and covered bond yields have gone negative. 

So to summarize, Mario Draghi sees no signs of bond scarcity (perhaps blinded by glitter and confetti?), while HSBC thinks that's a bit "strange," and Morgan Stanley doesn't really see what the problem is even as their own analysis shows that it is now "impossible" for Germany to fully implement their portion of the program under the capital key.

Meanwhile, FT thinks it's possibly important that thanks to the absurd consequences of NIRP-dom, the ECB may soon take the plunge into euro corporate credit sending yields on corporate bonds negative in the process in what one could easily call the most outrageous perversion of financial markets yet if it weren't for the fact that the BoJ is providing plunge protection for the Nikkei and if savers weren't subsidizing negative rate mortgages in Denmark. 

Thank you central bankers.