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Tuesday, 24 October 2017

On the ECB's next kitchen sink

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Anthony Peters looks at the expected yield curve impact of euro QE.

The ECB Central Council doesn’t meet until January 22, which is more than two weeks away, but the QE subject is already moving markets and dominating conversations on a minute by minute basis. Will they? Won’t they? How can they? How can they not? It’s too little, too late. It’s too much, too late. It’s not enough. It’s too late. It’s not what is needed. It’s just what is needed. And finally, how are they going to deal with the Greek elections three days later?

I think the prevailing wisdom seems to be that QE, if visited upon an economy with shock and awe, is good stuff, but that if it trickles out half-heartedly, as the prospective ECB programme is about to do, it is most probably going to miss its objective. That does not mean, however, that it is not going to have some impact.

Bond yields will surely fall albeit that Europe has little need for lower rates. The principal effect of QE in the US and the UK will be recorded by economic historians as being of a positive psychological nature rather than of a measurable economic one and that is something the ECB’s programme, whatever it turns out to be, will surely fail at.

Doesn’t that smack of throwing the kitchen sink at the last kitchen sink?

Crushing the curve

I was yesterday talking to an old guvvie bond dog, Ian McBride of Mirexa Capital, who has over the past 25 years bought, sold, spread and reversed more bonds than you can throw a stick at. He has done some sterling work on a model covering the QE subject and concludes, based upon an assumed QE programme of €500bn and an application of a GDP-weighted capital key (if my memory serves me right), that around 85% of the volume of Germany’s 2015 issuance will be bought but only 50-odd% of French issuance and closer to 30% of Italian issuance. (NB: The ECB will not be allowed to buy at auction but will have to take paper out of the secondary markets.)

On that basis, Bunds would be bid to buggery and the curve will surely get crushed; we might well see even 10-year yields head towards zero. On the other hand, Italy will have to find cash buyers for about two-thirds of its €270bn funding requirement. Ireland is reckoned to have a funding requirement of no more than €8bn this year, a decent chunk of which should get done today when it issues its seven-year bond. Using the aforementioned capital key, the ECB might find itself obliged to buy more Irish bonds than it will actually be issuing in 2015. These are of course only musings but are interesting, irrespective.

I was asked by one market operative whether the ECB would be allowed to buy in bonds with a negative yield. I have checked and it appears not to be a problem. In fact, there are only two notable constraints to the buying of bonds which are that, as said, bonds must be transparently taken out of the secondary market and that no bonds issued by financial institutions can be purchased. Other than that, and assuming the application of the capital key, it’s a free for all.

Corporates and CoCos

Meanwhile, the corporate bond market is gradually waking up. Not surprisingly, it is the US which is leading the charge with some fairly plain vanilla issuance by such old stalwarts as Ford and GE. The big deal of the day was for FedEx, the logistics group which came out of the blocks with a four tranche deal at five-year, 10-year, 20-year and 30-year. However, while the books were still open, a fifth, 50-year tranche was announced – surely on reverse enquiry – and thus we got US$250m of a 4.5% 2065 at 200bp over the long bond which was 40bp cheap to the original 30-year.

One might have thought that buying a bond with a duration of 20 and a convexity of 6.68 when the long bond is at 2.50% would be scary stuff as a 100bp back up of yields will wipe 16½ points off the price but fear of long rates heading back north does not appear to prevail currently; never mind tomorrow, show me the coupon today! I remind that as recently as last September the 30-year yield was still at 3.37%.

I will desist from listing yesterday’s losses on stock market indices, the latest new low for oil or the decline in other commodity prices – other than gold – but will remind that there are some serious credit implications. This is surely not a good time to be punting around in CoCos or in any other subordinated bank risk for that matter. Someone out there is bandying around the idea of an imminent outbreak of “Lehman squared” which I think is a bit of big call – black swans distinguish themselves by being unforeseeable and unexpected – but I do agree that there have to be risks to some banks’ balance sheets which we know little about.

Frankly, I would not be at all surprised to see the generic spread of Additional Tier 1 bonds to be 100bp wider in three months from now unless oil pretty smartly reverses its current decline.

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