When the sell-off in German Bunds first got going, it looked like a temporary squeeze, with the largest position in the market – the ECB QE trade – coming under pressure after much weaker-than-expected Q1 GDP on 4/29.
However, as (Draghi mouthpiece) Goldman notes, there is something more than supply dynamics or ECB communications going on, as the Bundesbank (Buba) buying has fallen short of its purchases (in average maturity terms) from the very beginning. Goldman warns, ominously, this kind of signal – from the key hawk in the Eurosystem – has the potential to undercut the credibility of ECB QE, since it weakens the portfolio balance channel.
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Goldman previously argued that the weak activity reading rattled a market that had been operating on a core thesis of strong US growth. The resulting uncertainty caused Bund yields and EUR/$ to rise, with the DAX also selling off on the day. Since then, something more ominous has come into play...
One clue has been the communications ping pong from the ECB. On May 18, Executive Board member Coeure said “the rapidity of the reversal in Bund yields is worrisome,” citing it as another example of “extreme volatility in global capital markets.”
ECB President Draghi sent the opposite message on Jun. 3, saying “one lesson is that we should get used to periods of higher volatility,” followed on Jun. 10 by Executive Board member Coeure stating that “the ECB does not intend to counter [Bund] volatility in the short term."
Goldman took a dim view of all this in our last FX Views, even if a charitable interpretation is that President Draghi basically sent a dovish message on Jun.10 and simply didn’t want to signal "activism" in the face of short-term volatility.
After all, one goal of ECB QE ought to be to make Europe’s safe haven asset (Bunds) expensive, so that investors get pushed into risky assets like equities and the Euro periphery.
If there is ambivalence, it sends a harmful message to markets that, after all, are still new to ECB QE. This might be one reason why EUR/$ has held up, even as US data (payrolls, retail sales) have picked up.
There is something more than supply dynamics or ECB communications going on, something that has the potential to undercut the credibility of ECB QE.
As Goldman explains below, the Bundesbank has reduced the weighted-average maturity of its Bund purchases from 8.1 years in March to 5.7 in May, in contrast to the Eurosystem as a whole where this number has stayed around 8.0 years.
It's not like the Bundesbank is not spending its money (as we noted previously, in fact May - just as ECB telegraphed to its most valuable clients - saw purchases soar)..
but it is what it is spending it on, not how much that matters...
The ECB publishes monthly data for the outstanding stock of bonds bought under its QE program, together with a weighted average for the corresponding number of years to maturity. We use these data to calculate the average maturity of monthly buying by the Eurosystem (Exhibit 3).
This shows that the average maturity of ECB bond buying is around 8.0 years, in line with what Executive Board member Coeure said in his May 18 speech. However, while Italy and Spain see purchases that have an average maturity above that of the outstanding debt stock, Bundesbank buying has fallen short from the very beginning.
There are obviously many explanations for what is going on (see below).
But this kind of signal – from the key hawk in the Eurosystem – has the potential to undercut the credibility of ECB QE, since it weakens the portfolio balance channel.
After all, it was supposed to be low yields in core Europe into risk assets. If those yields now rise and become more volatile, such portfolio effects will be lessened.
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What Goldman is implicitly suggesting is:
Buba is intentionally focusing on shorter-dated maturities, unwilling to throw away its cash on the high prices that bond holders will demand for high cash coupon debt (when in fact the central bank should be price agnostic if it had truly "got ECB religion")
So is Buba really sabotaging Draghi?
Or is this a warning to Weidmann to stop being stingy with the bond buying?
Remember also, Goldman needs low-ish bond yields and low-ish volatility for its QE-driven weak EUR trade to pay off...
It remains our view that fundamentals will ultimately take EUR/$ lower in line with our forecast. That said, we see recent Bund volatility and what it means for the credibility of ECB QE as the first material challenge to our view.
So there's ulterior motives for this 'warning' whereever we look.
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Perhaps it is also the timing of such a note that implies a louder warning... with Grexit around the corner, those "expensive" long-dated Bunds are going to be even more pricey when Buba needs to step in and buy to prove contagion is not there.