Over two years ago in "Desperately Seeking $11.2 Trillion In Collateral", Zero Hedge first warned that as a result of relentless central bank monetization of debt, liquidity in bond markets would decline at an ever faster pace even as, paradoxically, these same central banks added "phantom liquidity" (the topic of another post from two years ago) to equity markets in their attempt to artificially inflate stock prices to record levels without fundamental justification.
Sure enough, with the usual 2-5 year delay, in 2015 the primary financial topic sweeping the mainstream financial media and all the "serious" pundits, is the collapse in bond market liquidity.
Some, the more naive ones, blame regulation. Others, such as iconic Citigroup credit strategist Matt King strategist explained - once again - that Dodd Frank is a negligible reason for the total plunge in bond market liquidity which is the result of, just as we warned, central bank intervention and the relentless ascent of algorithmic trading.
But even as everyone is finally arguing about the cause of the plunging bond market liquidity and has no clue how to resolve this biggest nightmare for what once used to be the deepest and most liquidity of markets (at least not without forcing central banks to sell the trillions in bonds they hold, a step which would free up collateral but also result in the biggest market crash ever), a far more ominous question has reappeared. One which, as usual, we asked nearly three years ago: what happens when central banks soak up too much liquidity.
Our answer, at that point, QE will have officially failed, because instead of lowering bond yields - which as a reminder is the primary QE transmission mechanism, one which forces investor to reach not only for yield but also for risk in other asset classes such as equities - any incremental bond purchases will start raising yields as the adverse impact from the illiquidity "premium" surpasses the price appreciation benefit from frontrun central bank buying.
Impossible, you say?
Not only not impossible but in one country it just happened. Sweden, and as Bloomberg sarcastically notes, "It’s probably not what the Riksbank expected."
What is "it"? Precisely what we said would happen three years ago:
Quantitative easing is supposed to drive down longer-dated yields. But as investors obsess over market depth, the Riksbank’s bond purchases are undermining liquidity and driving Swedish yields higher.
“The financial conditions -- the currency and the bond yields -- are moving in the wrong direction,” Roger Josefsson, chief economist at Danske Bank A/S in Stockholm, said by phone. The assumption is that “the Riksbank wants yields to go down and the krona to weaken, but it’s been the opposite direction recently. That should pose a problem.”
As can be seen on the chart below, Sweden’s 10-year government-bond yield, which traded as low as 0.2 percent in April, was at 1.1 percent on Tuesday. Its five-year yield was 0.4 percent, after trading below zero just two months ago. And though Swedish yield spreads have narrowed relative to German bonds, investors can still earn about 15 basis points more by holding AAA-rated 10-year notes issued by Sweden than they can holding similar notes from Germany.
Why? Danske Bank explains: “Swedish rates continue to trade strong relative to Germany because of a lack of material in the repo market as a result of the Riksbank’s QE program.”
The Riksbank targets about $10 billion in government bond purchases as it tries to revive consumer-price growth after months of deflation. That’s about 14 percent of the market or 3 percent of Sweden’s gross domestic product. Any efforts to expand asset purchases would deplete Sweden’s already limited sovereign debt supply, SEB AB and Danske Bank have said.
Adding insult to injury, now that the "virtuous QE cycle" is broken, the extra yield is adding to the appeal of the krona. "Since the Riksbank started its bond-purchase program in mid-February, Sweden’s currency has appreciated more than 4 percent against the euro. It’s up 5 percent against Norway’s krone and is 3 percent higher versus the dollar."
That will make it harder for the bank to prevent disinflation as import prices decline.
And since Swedish QE has now officially broken and every incremental monetization will merely boost yields that much higher as the bonds become ever scarcer, the Riksbank can well proceed to monetize more... only to end up with higher yields... and an even stronger currency!
Which is precisely the opposite of what QE is intended to achieve.
And just like that, for the first time ever we see just how the closed QE loop transitions from virtuous to absolutely vicious, and how suddenly the central bank is left without any recourse to push yields lower as the very mechanism that has been designed for this now is pushing yields higher.
The good news for the rest of the world is that there is still some unencumbered collateral left, and that - at best - the world's central banks probably have 2-3 years of monetization dry powder left. After that it's pretty much game over... and the monetary paradrop.
For Sweden, however, it may be far too late. Then again, the locals don't seem too concerned.