As we showed yesterday, while the rest of the European bond market has suffered from the some "trumpflation-linked" weakness in the long end as US Treasurys in the aftermath of the Trump election as inflation and new supply fears grow, short-dated German bund yields unexpectedly plunged to record lows...
... as a result of what appears to be a massive year-end collateral shortage (which has come in about a month early) with demand for German collateral soaring and reflected in repo funding levels as funds are now forced to pay up to 1.5% to borrow a 10-year Bund, up from some 0.40% a year ago, according to Icap data..
Today we saw more of the same in early trading, as the German 2Y continued to outperform on collateral shortage fears, which likely prompted Reuters to report that the ECB is looking for ways to lend out more of its huge pile of government debt to avert a freeze in the €5.5 trillion repo market that underpins the financial system, manifesting in the surge in short-term Bunds.
While the ECB has bought more than a trillion euros ($1.06 trillion) of euro zone government bonds in a bid to shore up economic growth and inflation in the euro zone, in doing so, it has taken away the key ingredient for repurchase agreements, or repos, whereby financial firms lend to each other against collateral, typically high-rated government bonds such as Germany's. Repo, as covered here extensively over the years, is the core lubrication of debt capital markets, and is used by investment funds to finance trading and is regarded by the ECB as a key avenue to transmit its own monetary stimulus to the economy. More details:
A freeze in repo activity risks undoing some of the ECB's stimulus by hampering lending between financial companies and leaving bond markets vulnerable to sharp selloffs.
To avert this, the ECB wants to make it easier for banks to borrow the bonds that it has bought so that they can be used as collateral for repo loans, the sources said.
Possible changes include reducing charges for firms which fail to return on time the bonds they have borrowed, accepting new types of collateral and extending the duration of loans.
"If liquidity dries up there are more fails and banks are more cautious when it comes to making the market," one of the sources said. The sources added the issue will be discussed at the ECB's Dec. 8 meeting, when rate setters will decide on whether to continue purchases beyond March and ensure they can still find enough bonds to buy.
Any decision on bond lending will depend on what other changes the ECB makes to its asset-purchase program and might not be finalised in December.
While Europe is not alone in its central bank dominating the repo market, with the Fed likewise having quietly become the biggest player in the US repo market as well, the problem appears to be most severe in Germany.
With the ECB now owning more than a quarter of all outstanding German bonds as it continued to slowly nationalize European debt, funds pay up to 1.5% to borrow a 10-year Bund, up from some 0.40 percent a year ago, according to Icap data.
This is putting a strain on investors as they face increasingly frequent demands to put up cash or liquid collateral against their derivative positions due to new regulation.
"If a pension fund can’t borrow a bond in time, it may have to sell its own cash bond, foregoing a potential return in the future to fulfill a short-term obligation," Godfried DeVidts of the International Capital Market Association industry body said. "So basically the pension funds are getting poorer and the pensioners too."
Any ECB decision how to remedy the "repo freeze" would meet further roadblocks as it would then have to be implemented by national central banks, which own the bulk of the debt bought by the ECB and bear the risk for their own bond-lending schemes. "This means the most radical proposals may run into resistance, the sources said."
And while the actual remedy to be implemented by the ECB is yet to be determined, the concern that the ECB may inject more securities to unfreeze repo has quickly rippled through the bond market, and as a result Germany's two-year bond yields rose: the two-year Schatz yield shot up 6 basis points from the day's lows to minus 0.69 percent, having hit a record low earlier in the day. Other euro zone bond yields also rose, reversing earlier falls.
The most notable move was in 10Y bunds which jumped to 0.278% after hitting a session low of 0.21%. French 10Ys also rose over 7 bps, as did Italian bonds.
Bund futures slid to a session low of 160.78, losing as much as 62 ticks, following the Reuters report.
The best summary of the quandary the ECB has found itself in comes from David Schnautz, interest rate strategist at Commerzbank, who first pointed out the collateral shortage, and who said that "there is something going on with the repo markets and we can see that as soon as the ECB starts talking about tackling these problems we see a market reaction."
For now, despite the modest pick up in yields, the market is confident that the collateral shortage, something we have warned about since 2013, will be resolved although the specifics could lead to another major asset repricing, especially if it comes at a time when the ECB and BOJ are expected to provide the "cross-border" helicopter money to finance Trump's stimulus plan, as reported yesterday.