The ECB, market liquidity fear and an expandable shopping list.
The ECB did stuff last week, namely it cut rates while downplaying further cuts, tried to protect the banks under its care from negative rates and pledged to boost its balance sheet due to its fear of market liquidity reduction.
That was considered, after some confusion, impressive by markets, amongst other things because of the ECB’s shift to buying up private assets — “investment-grade euro-denominated bonds issued by non-bank corporations established in the euro area are to be inccluded in QE,” as Deutsche summarised while others wondered aloud about what else the ECB might end up buying.
The problem so far, though, is that the universe of assets it can now buy is actually smaller than one might have originally thought.
As BofAML charted it:
Or Deutsche with a more geographical skew:
You can quibble about the size of that available universe but the broad point is the same — the amount of IG credit the ECB can now buy is not as large as it appears at first glance.
More so, the ECB is constrained by market liquidity concerns. People and central banks are worried about people and central banks being worried about corporate bond market liquidity …
As JPM’s Niko Panigirtzoglou said, with our emphasis:
So in all, we think the lesson from existing ECB asset purchase programs is that the ECB should limit its purchase pace to only a small portion of secondary market trading volume. Less than 10% and perhaps closer to the 5%, which is the pace the ECB currently applies to its government bond and asset backed security purchase programs.
As explained above, the estimated trading volume for EUR-denominated IG Corporate bonds, including bank bonds, is €100bn per month. We assume that half of this secondary market trading volume is accounted for by bank bonds. For example, of the top 10 Corporate IG bonds by trading volume, half are bank bonds. This implies non-bank Corporate IG trading volume of around €50bn per month. Applying a ratio of ECB purchases to secondary market trading volume of between 5%-10%, implies monthly ECB purchases of between €2.5bn to €5bn.
The capacity of the ECB to purchase corporate bonds is also a function of the how the primary market responds to ECB buying. The primary market issuance is running at a rather slow pace of around €12bn a month currently. So again assuming ECB primary market purchases of 5%-10% of issuance, would add another €1bn per month of potential ECB buying. This capacity would naturally expand if the ECB program manages to bolster issuance going forward, e.g. if it manages to induce corporates to buy back their own equity.
Without an expansion of primary market capacity, the above analysis suggests that a feasible purchase pace by the ECB in order to avoid damaging the market liquidity and the functioning of the European corporate bond market too much is between €3.5bn to €6bn per month.
Finally, another consideration for the ECB should be trade sizes and market depth. The Trax report provides data on average trade sizes across fixed income sectors, which can serve as proxy for market depth. The average trade size for IG Corporates has been €850k during 2015. This is a lot lower than that of Government bonds, at €7m, or covered bonds at €2m. This means that the ECB corporate bond purchase program will be more difficult and more fragmented from an implementation perspective, than either the government bond or the covered bond purchase program.
But what appears to be encouraging is that the average trade size in the European Corporate IG market is not too low vs. that of the US Corporate IG market. According to TRACE, the average trade size for US IG corporate bonds was lower at €500k during 2015, excluding 144A transactions. In other words, at face value, this particular market depth proxy appears to be higher in European corporate IG bonds vs. the US ones. In addition, turnover, i.e. trading volumes divided by outstanding amount is also higher in European Corporate IG vs. its US counterparts, 1.1x vs. 0.9x. This does not mean that the European corporate bond market is more liquid than the US one. The opposite. The US Corporate IG market is generally more liquid and more established than its European counterpart. It is perhaps the more limited coverage of Trax relative to TRACE data which biases upwards the market depth metric for European IG Corporates. But again, even if, because of coverage and data quality issues, we had to halve the average trade size from the reported €850k to €425k, for example, it would still imply a market depth level that it is worryingly low vs. that in the US
So the amount of stuff the ECB will buy is v much smaller than you might think — as highlighted, the estimate based on current available pools is that the ECB can only buy around €50bn a year through primary and secondary markets — even if its effects are potentially outsized. On one side of that argument you have JPM saying that the move implies easier credit conditions which will help out banks and corporates while lowering financial distress (potentially leading to more share buybacks). And on the other hand you have real economy concerns — for example, Citi’s Steven Englander, who notes that corporate borrowing costs are already cheap and have been come down both for high grade and less impressive borrowers.
In fact we are just coming back to where we were a year ago in terms of borrowing costs. It still relies on the hope that lower yields leads to higher aggregate demand. Lower peripheral government yields means lower risk premium and less stress on finances but we have been there before without it translating into stronger aggregate demand.
But, never forget there’s a lot more stuff that the ECB could decide to buy soon. As Polemic’s Pains said: “Dr. Aghi has opened up a huge new highway in buying corporate bonds which could well lead to the road of equity purchases. This in its own right is a new Draghi Put and ’should’ be exceptionally bullish for European equities.”
Which will give us lots more worries about market domination too.
From Panigirtzoglou one last time:
Assuming the ECB will be willing to navigate eventually into other private sector asset classes if macro conditions deteriorate in the future, the asset universe could expand to include uncovered bank bonds (€1tr), bank loans (€10tr) and equities (€6tr).