Liquidity fears rise as QE dries up repo

When the European Central Bank launched quantitative easing a month ago, eurozone government bond markets braced for trouble. The €60bn-a-month asset-purchase programme would create severe shortages of bonds, markets would dry up and prices go crazy, participants worried.

As the ECB prepares for its latest policy meeting on Wednesday, experience so far suggests some immediate fears were misplaced - but that the efforts of Mario Draghi, ECB president, to prevent the eurozone economy falling into a deflationary slump have created serious behind-the scenes distortions, especially in German government bonds.

"There is evidence that trading volumes have fallen significantly recently across eurozone bond markets," says Laurence Mutkin, global head of rates strategy at BNP Paribas. "That loss of depth in markets could create serious challenges for investors and markets at some point."

Since March 9, when the ECB started buying bonds, yields, which move inversely with prices, have tumbled, especially on German government debt. A quarter of eurozone government debt is trading at negative yields, and benchmark 10-year German Bunds could soon join the club, analyst reckon.

In thin markets traders and strategists privately express fears of events similar to the sudden "flash crash" last October in US Treasuries.

Eurozone QE created risks because - unlike earlier US and UK QE programmes - it was launched when yields were already extremely low, and governments were reducing fiscal deficits, restricting bond supplies. In such an environment it is harder for traders to make money, and bond owners are reluctant to sell because there is nowhere else to put their money.

"Banks are not willing participants and there are no willing sellers," warns Steven Major, head of fixed income research at HSBC. "There could be a sellers' strike."

Moody's, the rating agency, forecast in a report on Tuesday that the ECB could run out of eligible bonds from some governments "around the turn of the year" - well before the QE programme is expected to end.

Such fears have yet to translate into obvious problems in markets. "The consensus of opinion beforehand was that the programme would be hugely problematic and lead to significant mispricing," says Zoeb Sachee, head of European government bond trading at Citigroup. "Relative to those perceptions, the first month of QE has been quite smooth."

What has been noticeable, however, has been a fall in market activity. Using data on German bond futures contacts as a proxy for trading in cash bonds, BNP reckons market turnover has fallen this month to levels normally seen at the year end, when dealers square off trading books.

"There has definitely been a drop in the overall level of activity since the start of the programme, but it is not easy to pin down the precise cause," says Mr Sachee.

"It may be that investors are just waiting to assess the impact of QE before making significant asset-allocation decisions, or that with yields so low there is simply far less trading to do."

Yet the relative calm could presage problems ahead. Signs of tensions have emerged in European "repo" markets - in which bonds are used as collateral to obtain cash via repurchase agreements.

Bankers argue that repo markets help the functioning of global finance, providing liquidity and making it easier to match buyers and sellers across asset markets.

German government bonds are some of the highest quality collateral, so shortages could have wide repercussions. With demand soaring, holders have been able to repo them and obtain cash at increasingly negative rates. The implied interest rate on repo borrowing for six months starting in six months has fallen to minus 0.4 per cent, according to UBS.

Such stresses in repo rates could quickly spread, reducing liquidity in secondary markets, warns Justin Knight, fixed income strategist at UBS. "The repo market is very, very worried about a squeeze."

Against the backdrop of those tensions, it is less of a surprise that yields on two-year or three-year German government bonds have fallen below minus 0.2 per cent, the level the ECB has set as a floor for its purchases. If investors can borrow at even lower rates via repo markets, they can still make money buying slightly less negatively yielding bonds.

The ECB has sought to alleviate repo stresses by lending back to dealers the bonds it is acquiring under its QE programme. The objective is to avert collateral shortages. But banks complain that the ECB is charging too much for the service. Fees set by the ECB seem "very punitive" compared with those charged by the Fed for securities lending, JPMorgan analysts report in a research note this week. The contraction in the German repo market could intensify this year, the report warns, hampering market trading liquidity.

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation