Never having enough bonds

The European Central Bank might face new challenges with the exit of Britons. The fear of recession caused by the Brexit urged the markets to ask for protection, with this the bond yields from the secondary market of the core countries were pushed to a new minimum point. During this the yields of the European periphery countries, after the first reactions, have increased, later they started to decrease as well. Although the emission of 10-year bonds with negative effective yields, from the last week, hasn’t caused a problem to the German budget, national bankers might be intrigued by this situation. Let’s start at the beginning…

In March 2015 (after the announcement from January) the European Central Bank starts its asset purchasing program, at that time with a 60 billion euro budget. The rules are relatively simple: only 33 percent of certain bond series can be purchased, they cannot buy under the all-time bank credit interest rate, and the budget will be split among the member states based on the capital key. This key reflects the National Banks‘ share in the total capital, the size of population and the economy. Since smaller economies don’t have such a big bond market to satisfy all the criterions, by showing some flexibility, the Central Bank compensates this absence in assets with the government bonds of bigger economies.

 The distribution before the Brexit

Source: Bloomberg, UniCredit

The first turning point was in November 2015, when the end of the program was extended, the interest rate was also decreased from -0.2% to -0.3%. As the program period was extended, the Central Bank had to face instantly a minor problem. Due to the disciplined fiscal policy, dominating in Europe, the member states borrowed less; respectively, Germany, with the highest capital key, had already a surplus, namely its budget didn’t need new capital, which meant that later on this narrowed the spectrum of available bonds.

The second modification came after the meeting in March 2016, when the interest rate on credit was cut again with -0.1 to -0.4%. The budget was increased from 60 billion to monthly 80 billion, and according to the new regulations within the program the National Banks could allocate money into non-financial bonds, NBs could buy corporate bonds issued for investing purposes.

As I already mentioned earlier, after the Brexit referendum in July, in consequence of protection finding, yields from the secondary markets of safe countries, reached new minimum points. 49% of German and 39% of Finnish bond holdings got under the level of -0.4% on the week after the referendum.

It is not known exactly if the proportion of government bond purchases shifted because of the shortage in available bonds or in order to keep the financial stability of periphery countries. For Italy, who struggles with non-performing credits in a very high proportion (18%), this can be great news. Because the tripled number of available government bonds (after the financial crisis), the interest rate now is backed up.

  The distribution after the Brexit

Anyway the conclusion is the same, the Central Bank falls into its own trap, and it’s forced to take bigger risk in order to avoid the damage (purchased government bond yield- interest on deposits). Based on the strategies of Credit Suisse, with unchanged yields in the next semester the ECB will run out of purchasable bonds. Of course, in theory the regulations can be always changed. To mention only a few theoretical solutions, with lower deposit interest rate, by the modification of the capital key or of the 33% limit value, the problem can be countervailed.

At the same time investors can conclude the following lessons: because of the asset purchases and the National Banks’ regulation the difference in interest rates of certain member states and the yields within the countries can show strong distortions. They don’t bear with such a market indicator role as before the quantity relaxation and the zero/negative interest rate policy periods. Currently the post-Brexit changes in the proportion of National Bank’s purchases narrows further on the difference in interest rates of certain member states, by this distorting the price of sovereign risk.

Original date of Hungarian publication: August 3, 2016