ECB Watch:- Slowly Does It As Tipping Point Approaches
6 September 2016 by Mark Holman
The highlight in a busy week for central bank commentary is naturally the ECB meeting and press conference on Thursday. Speculating on what the ECB might or might not do this month has not really taken up much desk time, but the consequences of the policies currently being implemented has been a source of deep discussion as they are now having a profound effect on the market.
So firstly, why are we less concerned with Thursday’s meeting?
This is because we think the ECB is already close to being “all in” in terms of the measures it is using. However, it is still a long way short of “all in” when it comes to implementation. So far in this latest round of QE it has purchased just over €1 trillion of eligible assets, and this is only just past the midpoint of what it committed to.
In making its commitment to this strategy the ECB will have sized the market, scaled its actions accordingly and then tested them under various yield changing scenarios. It may well be that with the recent rally in yields that the ECB will have to recalibrate its policy further, it has always been upfront about this. The recalibration is what a lot of commentary has been focussed on. For example:-
Will the ECB reduce interest rates further to allow it to buy bonds at lower yields? Will the ECB allow itself to buy greater percentages of each issue? Or will the ECB really reach out and change the capital key, which determines how much of each nation’s debt it could buy? The first two of these policies may be easiest to implement, but that probably only buys the ECB a little breathing space; however, the latter would make a big difference as well as fostering a further healing of the transmission mechanism as it would benefit the periphery most. Much as we would like the latter to happen, we recognise that this is a high hurdle for the ECB as it is a rules based institution. Hence we think the meeting this week may not be as exciting as it is being billed up to, even if the ECB does extend the programme by another 6 months.
What we are really focussed on is the portfolio effect of the ECB’s policies. After the initial shock of announcing extraordinary policies, nothing much happens in the immediate aftermath. It takes time to buy up enough size within a very large market to have the long term desired effects, however, once critical mass is reached, this is where longer term change can take effect.
This is best explained by an example. This week we looked at the € investment grade corporate market which now yields just 0.60% as an index, a full 38 basis points higher than the € government market! Let’s further say that a fund of IG € corporates had a yield of 1% by cherry picking securities. The universe of bonds that the IG manager could buy that yield 1% or above is now just €1.5 trillion, and that includes large parts of the peripheral government markets. If yields drop by just 10 basis points, then the universe of securities still yielding 1% shrinks by €180 billion, and this does not include the bonds that the ECB already owns. Now bearing in mind that real money investors have to pay fees, that 1% yielding fund arrives to the end investor at a yield that is perilously close to no longer working for the investor.
So what do the fund managers do? Well to the extent that they can, they will take some higher yielding off benchmark bets. Those off benchmark bets are primarily being focussed in € high yield, to the extent now that the biggest investors in € high yield are now € investment grade funds. Now € high yield is a much smaller market, at just 1/7th of the size of the IG market, so the effects in this market as the QE induced wave of buyers hits it, can be much bigger, and the effect can be much quicker.
In the UK an IG corporate bond fund can buy up to 20% in non IG, so it is easy to see how the squeeze can dominate a market.
In summary, the technical effects of Eurozone QE are really taking hold and are now at a tipping point. With Mario Draghi just halfway through his programme, his team of analysts will be monitoring these intended effects very closely as they contemplate the duration and magnitude of their programmes.
Even though the ultimate intended inflationary effects are not working yet, the portfolio effects certainly are.
For those investors who are more focussed on £ markets, remember this market is significantly smaller, so the portfolio effects could happen a lot quicker.
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