Back in April, BofA analyst Barnaby Martin suggested that in order to mitigate the potential fallout from the end of the ECB's QE, the European Central Bank could engage in an "Operation Twist" to flatten the curve and keep term premiums low, or in other words, to avoid chaos for the European bond market.
BofA: "Our economists have recently talked about the possibility of an “Operation Twist” to the ECB asset portfolio, to help keep term premiums low."— zerohedge (@zerohedge) April 13, 2018
Overnight, and a little over two months later, Reuters reported that the ECB is indeed considering buying more long-dated bonds from next year as part of its bond reinvestment strategy to keep euro zone borrowing costs in check, effectively copycatting what the Fed did with its own Operation Twist first in 1961 and then again 2011, where the central bank replaced short-dated paper with longer-term debt to lower market interest rates and boost an ailing economy (which begs the question: is the European economy that ailing that the ECB is scrambling to come up with QE extensions even at a time when the Eurozone is supposedly recovering).
In this particular case, the "Twist" would be aimed at limiting the natural aging of its 2.6 trillion euro bond portfolio and keeping a lid on long-term bond yields, a key determinant of borrowing costs, bu maintaining a bid for long-term debt while short-term holdings are sold.
As is well known, while the ECB announced recently it would end its QE (absent major market shocks) in 2019, it will continue to reinvest the money it gets from maturing paper for a long time, to ensure cash in the euro zone remains abundant.
And, according to Reuters, conversations with five central bank sources show policymakers are wary of seeing long-term yields creep back up as the ECB’s stock of bonds ages, or “loses duration” in market parlance. To avoid this, the ECB is considering buying more longer-dated bonds, generally seen as maturing in 10 years or more, with the cash it gets from maturing paper. Additionally, since the ECB remains constrained by how many German bonds are available, the central bank may also smooth out its reinvestments by occasionally deviating from its “capital key” rule, Reuters sources added.
The sources said that any such deviation should be minor and that the main rule behind the contemplated changes is to give the bank more flexibility, not fundamentally alter how cash from expiring bonds is reinvested.
Why Twist and not shift to other securities? Because this option was reportedly seen as a more palatable option than increasing purchases of corporate debt, which have attracted criticism for being too risky after one of the companies the ECB had invested in found itself embroiled in an accounting scandal.
“The idea is to keep the duration of the portfolio as much as possible,” one of the sources said. “So it wouldn’t be the end of the world if we deviated from the capital key.”
To be sure, for now the details are scant and the ECB could be merely testing out another Trial Balloon idea via Reuters, which is clear to point out that the issue was not discussed at the ECB’s June 14 policy meeting, when rate-setters merely tasked ECB committees to come up with proposals; a full decision is expected in July or September.
And while Twist would certainly keep long-rates low indefinitely, and certainly for the duration of the ECB's reinvestments, the problem is that such a move would further cripple European banks who are struggling to make profits at a time when NIRP and QE have collapsed Europe's yield curve, and led to the unprecedented outcome of Deutsche Bank's US operations failing the Fed's stress test.
As expected, the European yield curve collapsed on the news, with the German 5s30s 5bps as much as flatter on the day, as Bond yields across core and semi-core jump, up 5-6bps across the 5-year sector, while the long-end is supported, as the market reprices to adjust for expectations of more ECB purchases on the long end.
As a reminder, two years ago Deutsche Bank was complaining that the ECB is the root of all of the bank's problems. Therefore, it is safe to assume that the biggest European bank will hardly be excited by this particular proposal, which may therefore be shut down by the ECB hawks before too long.
For now however, the global flattening continues as the ECB remains stuck between a rock and a hard place: wanting higher inflation, yet completely unable to unlock the longer-end of the yield curve to price in just that outcome further perverting the "market."