Specter of Japan Bond Drought Looms in QE Prospects: Euro Credit
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(Bloomberg) — Europe is about to look a lot more like Japan.
With deflation a real risk and growth at a standstill, euro-region investors speculate they will soon add one more Japanese attribute to their list of woes: a bond-market drought.
As the European Central Bank weighs a new round of stimulus, JPMorgan Chase & Co. estimates a 500 billion-euro ($580 billion) program of sovereign-debt purchases would consume all, and more, of the region’s net issuance this year. That poses the prospect of a liquidity squeeze like that facing the debt market in Japan after years of quantitative easing.
“This could potentially lead to a shortage of high quality paper and a sharp drop in trading activity,” said Salman Ahmed, global strategist at Lombard Odier Investment Managers in London. “While it may not have a massive impact on a day-to-day operation, the risk is that once there is a spike in volatility or a turn in sentiment, the rout will be magnified.”
Yields on euro-area bonds from Austria to Spain have fallen to records this year as the ECB has signaled it is ready to begin buying sovereign debt to stave off deflation. Consumer prices in the 19-nation euro area contracted 0.2 percent last month, according to official estimates before the final figure is released today. German 10-year rates dropped to 0.423 this week as the yield on similar-maturity Italian bonds slid to 1.706 percent.
QE Models
ECB staff presented policy makers with models for buying as much as half a trillion euros of investment-grade assets, or government securities with ratings ranging from top AAA to at least BBB minus, a person who attended a meeting of the ECB Governing Council said last week. Central bank officials next meet on Jan. 22.
JPMorgan estimates that bonds issued by 11 top sovereign borrowers in the region this year will be 766 billion euros. The sales will be used to refinance 566 billion euros of debt redemptions, leaving net issuance at 200 billion euros.
If the ECB starts buying government bonds over the next 12 months from January, the amount will absorb on average around 240 percent of net issuance, the bank projected.
“Some distortion is to be expected when you introduce a big buyer into the market,” said Aditya Chordia, a rates strategist at JPMorgan in London. “Liquidity is one of many important factors that the ECB will need to consider when it announces the quantitative-easing program.”
Declining Trade
While the pool of government bonds in developed markets has more than doubled to $21.9 trillion from $9 trillion five years ago, according to Bank of America Merrill Lynch data, trading activity has declined.
This is an unintended consequence of central bank stimulus programs, which have included lowering interest rates close to zero and buying assets to boost demand in economies crippled by the financial crisis. Regulators’ efforts to rein in risk-taking among the world’s biggest banks has also disrupted what is considered among the deepest and most liquid markets in the world.
Market Depth
Bond trading has declined even as issuance has grown, with less than 5 percent of the market changing hands each month in the U.S., down from about 20 percent in 2007, according to the Basel, Switzerland-based Bank for International Settlements.
The declining market depth and lack of volatility that accompany large-scale purchase programs by central banks may make it more difficult to determine the proper prices of securities, analysts said. The risk is that the bond market will become less efficient in times of turmoil.
In Japan, where the central bank’s bond purchases are about equivalent to annual public debt sales, primary dealers cautioned the government late last year that the program is “not normal” as it saps liquidity. Investors traded no two- year bonds at all on Jan. 6.
Royal Bank of Scotland Group Plc said last month it will give up its position as a primary dealer of Japanese government bonds. Yusuke Ikawa, a strategist at UBS Group AG in Tokyo, says opportunities for profit are disappearing because of the Bank of Japan’s purchases.
ECB Plan
The “price discovery function” whereby the market determines the cost of a bond based on supply and demand, is “low,” according to minutes of a meeting between the dealers of Japanese government bonds and the Ministry of Finance in November.
JPMorgan’s Chordia said one option is for the ECB to put a constraint on the maximum amount of each bond it can buy.
“It might, for example, have a 40 percent cap per bond to avoid creating a liquidity problem in smaller markets,” Chordia said in a phone interview on Jan. 13.
Increased regulations and tighter capital rules have damped bond dealers’ ability to make markets or facilitate trades for clients. The problem it has caused is not confined to smaller markets as turmoil on Oct. 15 showed.
The $12.3 trillion U.S. Treasury market went into a gyration that day as investors reversed bets the Federal Reserve would raise rates, amid concern Ebola would spread worldwide and as war escalated in the Middle East.
At 8:30 a.m. in Washington that morning, the Commerce Department announced a decline in retail sales. By 9:38 a.m., 10-year Treasury yields had plunged 0.34 percentage points, the most in five years.
The size of German bund futures that can go through the market at one time without moving the price, a gauge of market depth, fell 46 percent to 784 contracts in that week, from last year’s peak of 1,450 contracts in April, according to JPMorgan. It was 730 contracts as of last week.
“Liquidity has become an issue for a while and ECB’s QE could make it more pronounced,” said Michael Leister, a senior rates strategist at Commerzbank AG, the top primary dealer for German bonds. “That risk should be included in any investment decision. What we learned not long ago is that when we have a rout like the one in October, there is no place to hide.”
ECB news: NI ECB
To contact the reporter on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net To contact the editors responsible for this story: Paul Dobson at pdobson2@bloomberg.net Mark McCord, Todd White
