The British pound wasn’t the only thing stirring in FX markets on Thursday. Have a look at the EUR:
Ok, so we know what happened at 11 am ET. As we detailed earlier, that was Bank of England governor Mark Carney telling everyone what they already knew - policy easing from the BoE is on the way.
So what in the world happened at noon? For the answer, we go to Bloomberg:
“European Central Bank considering loosening of rules for bond purchases to ensure enough debt is available to buy in aftermath of Brexit vote, according to euro-area officials familiar with discussions.”
“Policy makers are concerned pool of securities eligible for quantitative easing has shrunk, people say.”
“Some Governing Council members favor changing allocation of bonds purchases away from size of nation’s economy toward one more in line with outstanding debt, one person says.”
That may sound kind of dry, but it’s actually a bombshell. The Cliffs Notes version here is that the ECB is running out of bonds to buy for its QE program. There’s a tail-chasing dynamic going on which it’s important for investors to understand because it effectively ensures the bank will be stuck in easing mode for the foreseeable future.
The ECB's QE program is confined to assets the yield on which is above the deposit rate. In other words, the central bank's depo rate is a floor. It's currently minus 40 bps.
Think about what dynamic the depo rate floor creates. When the ECB buys bonds, it drives rates lower. The more bonds they buy, the more bonds trade below the depo rate. The more bonds that trade below the depo rate, the less bonds there are to buy. But the bank keeps expanding the program when the program itself is shrinking the supply by driving yields below the floor! So what's the only solution? Well, you have to keep lowering the floor so there are more bonds to buy!
This dynamic is exacerbated by risk-off sentiment and expectations of more easing. The more people pile into safe haven debt either because something like Brexit spooks markets or because they’re trying to frontrun central bank buying, the lower rates go, thus shrinking the amount of bonds that are eligible for the ECB to monetize. This is one reason the central bank expanded the issue cap (basically the percentage of any one issue that the ECB can own) and started buying corporate bonds - they needed more dry powder.
Let’s take a look at a few charts to demonstrate what’s happening here.
First, here’s a chart and some commentary from Citi on the impact the post-Brexit rally in German bonds has had on the ECB’s plans:
“Figure 5 shows the number of months that the ECB can continue to buy Bunds under the PSPP for various levels of 10yr Bund yields. With 10yr Bund at - 0.10% there are just two months left while a rally to - 0.20% means that the ECB will more immediately have to change the parameters of its buying.”
(Chart: Citi)
The point is, when it comes to the ECB’s ability to monetize German bunds, they’re almost at the end of the road.
Here’s a look at how the picture looks for debt issued by other countries in the bloc:
(Table: BofAML)
So that’s BofAML’s projections for when the ECB will it the issue limit (33%) for various countries’ debt. Ok, so who cares, why not just shift the purchases to countries where there’s more room to buy (i.e. where more bonds trade with yields above the deposit rate floor)? Well, because the ECB’s QE program stipulates that purchases have to adhere to the capital key (more on that here for those interested).
You can begin to see why they’re thinking about changing all of these rules. If yields continue to fall, the ECB’s ability to implement more QE while adhering to all of the program’s restrictions will be choked off.
(Charts: Deutsche Bank)
So what does this mean for US traders? Simple. It’s further evidence that central banks are prepared to take the accommodative policy experiment even further and that means the punchbowl remains will likely remain in place. The risk party can continue.
But be cautious, because just as QE and rate cuts are becoming less and less effective when it comes to juicing inflation expectations and/or aggregate demand, so too will they eventually bump up against the law of diminishing returns when it comes to keeping stocks afloat. Whether that happens next week, next month, or next year, is anyone’s guess.
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