The ECB’s corporate bond purchase programme takes shape

Guest post by Marcello Minenna

With the awaited decision of August 4, even the Bank of England has put aside any delay and has steered towards an aggressive expansionary monetary policy to contrast the recessionary pressures due to the Brexit shock on market expectations. Apart from the expected interest rate cut of 25 basis points, different unconventional measures stand out: a 6-months resumption of the government bonds (Gilts) buying programme for a monthly amount of $ 60 billion, to be combined in synergy with the purchase of £ 10 billion of corporate bonds in 18 months.

The intervention in the corporate debt markets remains one of the most incisive tools in the hands of the central banks in order to induce a reduction in the funding costs of the non-financial sector and bypass the credit crunch due to a distressed banking system. At the state of the art, corporate bonds purchase programs are active in Japan, UK and in the Eurozone. On many occasions the Bank of japan has accelerated the pace of the purchases, even if now it appears it has reached its limits of intervention: the size of the market is not ample enough to support further expansions of the program, while the big Japanese industrial corporations are able to finance themselves at near zero interest rates (recently Toyota succeeded in placing a 3-years bond by offering a yield of 0.001%).

In Europe the program is instead in its infancy; at the present state, the room to maneuver is ample. The ECB has started the purchase operations of corporate bonds in June 2016 and only now the first stream of official data has begun to be released; few numbers that however are enough to verify if the first estimates made when the program was launched in March 2016, were at least realistic. According to the numbers published by the ECB, the 93% of the overall € 13.2 billion of purchases has been made on the secondary market, while only the 7% (that corresponds to € 1.16 billion) during the placement of new issues. This is not a negligible amount if we consider the traditional reluctance of the ECB to intervene in primary markets (the Quantitative Easing on government bonds is focused exclusively on the secondary market). From our point of view, this behavior signals a relative scarcity of eligible securities on the secondary market to sustain the planned pace of the ECB purchases.

On the basis of the experience of the Quantitative Easing, we estimated an overall pool of corporate eligible assets of € 550 billion and a monthly purchase ranging from a minimum of € 3 billion to a maximum of € 6 billion, without however taking in account the possible response of the market. In fact, in the hopes of the ECB, the non-financial sector should have increased the issues of debt to take advantage of the launch of the program. In this perspective, the historical records were not so favorable, since they showed a downward trend of the market issues (both gross and net of reimbursements), with a decline that was accelerating in the last months of 2015. In August 2016, we have to acknowledge that the real data of monthly purchases (€ 6.6 billion) lie outside the estimated range, but only for a small amount. Therefore it’s interesting to check if an “announcement effect” of the CBPP program has effectively pushed the non-financial sector to issue more debt. To this purpose, let’s observe carefully the following bar charts that represent the historical trend of gross and net issues of Euro-denominated bonds of Euro-Area non-financial corporations.

Figure 1.

Figure 2.

One can easily notice that starting with the month of March 2016, the big European corporations have increased considerably the issues (from € 30 billion to € 70 billion for what regards the monthly gross issues, from 0 to 20 in net terms). Hence, the good response of the market in the last four months and the consequently augmented availability of eligible assets could reasonably explain the dynamics above expectations of the ECB purchases.

The ECB is clearly aiming at having a positive, durable impact on the financing costs of the non-financial sector, to be achieved through a compression of bonds yields. In fact, the presence of the ECB as a buyer of last resort should provide to the corporations a stable, implied guarantee of a successful placement, a necessary condition to obtain lower yields. Even in this case, we have been able to retrieve useful empirical data to clarify the impact of the “announcement-effect” first and then of the purchases on the yields' dynamics (see Figure 3).

Figure 3.

In Figure 3, the historical trend of the Bank of America Nonfinancial Index from January to August 2016 is analyzed. The index is representative of the average yields non-financial Euro denominated investment grade corporate debt publicly issued in the Euro member domestic market. The observed pattern of the index shows a marked decline after the launch of the program by President Draghi in March 2016, a subsequent stasis and a relapse in the downward trend in conjunction with the start of the ECB purchases on the primary and secondary markets.

Overall it could be observed a reduction in the BofA index (that as said before should roughly correspond to a weighted average of yields of Euro-denominated corporate bonds) up to 90 basis points from the relative maximum registered at the beginning of 2016.

In summary, the first empirical evidence seems to confirm the potentiality of the ECB corporate bonds purchase programme in contrast to the credit crunch, at least in average at a European level. The data seem to highlight a significant responsivity of the new debt issues and of the average yields to the ECB monetary stimulus, which intensity appears to exceed the prudential expectations of the market. However, in the future months, it should be observed if the central bank will be able to continue the purchases at this sustained pace without impacting the market liquidity that remains very thin. Moreover, it’s not granted that lower funding cost for the non-financial sector will stimulate new investments.

On the issue, numerous doubts are still in place: in Japan, the big corporations have used the new liquidity trickling from the monetary authorities to the banking and corporate sector to benefit the existing shareholders, both directly by boosting the dividends and indirectly via buybacks. The buybacks have exploded from ¥ 1000 billion in 2012 to over ¥ 4000 billion in 2015, but visible effects have been appreciated only on the stock markets, where the ETF and corporate bonds purchases have been determinant in sustaining the Nikkei index to high levels. The dynamics of corporate investment have been largely unaffected by the BoJ unconventional measures. Paradoxically, the market rewarded these strategies since a reduction of the floating stocks increases by definition the earning per share. Time will tell. Surely, the small businesses, cut off by Draghi’s CBPP, will continue to endure a persistent credit crunch due to the difficulties of the Eurozone banking system, especially in peripheral countries. This is not exactly encouraging from the perspective of growth in countries where the small-medium enterprises are the core of the manufacturing sector, like Italy.

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Disentangling the nature of Italy’s capital flights

The ECB T-LTROs and the QE efforts are fueling significant outflows toward the core countries, driven by the non-banking sector. 

Guest post by Marcello Minenna


Net balances in the Eurozone continue to widen as capital flows from the periphery to Germany and other core countries. Much of the convergence in net balances that took place between 2012 and 2014 has reversed. As for the underlying reasons, we’ll show that empirical evidence points mainly to the combined effects of the new ECB programs of monetary expansion (T-LTROs and Quantitative Easing).  As of March of this year, Italy reported its largest Target 2 net deficit 2012 (€ -263 billion), followed closely by Spain (€ -262 billion) and Greece (€ -95 billion). Germany’s Bundesbank saw its surplus grow to over € +600 billion once again (see Figure 1).

Figure 1.

The ECB itself has seen its deficit widen to  € -90 billion due to quantitative easing purchases (see Figure 3).  Around 10% of QE assets are risk-shared between Eurozone countries and thus are accounted as an ECB “debt” towards National Central Banks (NCBs).

Figure 2.

This unusual accounting confirms that, also because of complex technicalities involved, a clear explanation of the driving components of this central banks' accounting method continues to prove elusive. Even the same ECB is explicitly warning not to infer bold assumptions from analysis of these data since simplistic explanations could lead to wrong conclusions.

Some academic research on the importance of Target2 balances has progressed considerably from the seminal but disputed work of Sinn (2012). The Sinn research has the merit in attracting attention on the relationship between the current accounts and the Target2 balances of Eurozone countries. A surplus in the current account should lead to a positive Target2 net balance, and vice versa. In this perspective, the Sinn research considers the Target2 balances in terms of a “stealth bail-out” of peripheral countries by the creditor central banks. According to Sinn, in the case a “debtor” central bank would leave the Eurosystem, the Target2 net balance would become immediately payable. A subsequent default of the debtor central bank would turn into a net loss for the Eurosystem to be absorbed jointly by all the remaining members (risk mutualisation or risk-sharing). Whelan (2012 and 2014) contested this view in many papers, pointing out that any central bank can always operate with “negative equity” (in other terms it could offset losses "printing money", without fiscal transfers from the taxpayers).  Now it seems understood (Szécsényi, 2015) that Target2 assets and liabilities could eventually lead to losses in case of a Euro break-up, but these should be a lot less than the raw net imbalances suggest.

At the present, a large part of the financial community seems to acknowledge that diverging net balances in the last two years are driven by purely financial transactions.  The current accounts of Eurozone countries are mainly in surplus (see Figure 2) due to the depreciating Euro and the compression of the level of prices and wages in the periphery (i.e. a phenomenon also known as internal devaluation). Hence, it could be inferred that the intra-European trade between Germany and the periphery (the Sinn hypothesis) is not the leading factor in explaining Target2 net balances.

Figure 3.

Digging deeper, it’s interesting to highlight also the strong correlation between the size of the ECB balance sheet and NCBs Target2 numbers. When the ECB inflates its accounts via expansionary measures, newly created money flows towards Eurozone banks that use it to regulate different kinds of transactions. When they are settled and accounted, these operations produce variations in the Target2 net balances. Let’s investigate the Italy’s case. As Figure 4 clearly depicts, Italy’s Target2 net balance and central bank balance sheet show a 96% correlation between 2011 and 2016.

Figure 4.

In the pursuit to understand movements in Italy's Target2 net balance, a detailed decomposition has been calculated by exploiting financial account data from the balance of payments (see Figure 5). The reconstruction has a good degree of precision, with little unexplained residual flows (the orange bars).

Figure 5.

In 2011 and 2012, core Eurozone banks sold significant amounts of Italian government bonds on the secondary markets because of an augmented perception of Italy’s credit risk (the green bars grew quickly). Those bonds were then purchased by Italian banks, which increased their exposure to national public debt. At the same time, German banks were deleveraging from long-term commercial credit exposure to Southern Europe. Net borrowing by the Italian banks on the Euro area interbank market also decreased markedly, due to the substantial reduction of deposits abroad and the missed renewals of existing loans. These phenomena (together with a progressively higher cost of financing) were signaling stress on the Italian banking sector’s funding practices  (the yellow bars). Together, this led to large capital outflow from Italy to the Eurozone core (denoted with a positive sign in core Target2 accounts; vice versa for Italy). The ECB’s LTROs and other unconventional measures have supplied over € 1 trillion to the Eurozone banks (€ 270 billion to Italy alone) that have been employed to finance the capital flight and transfer risk from the German banking system to the ECB.

When LTROs repayments began in 2013, the ECB balance sheets gradually deflated along with the Target2 net balances. Foreign investment in the Italian public sector resumed, though it did not reach previous levels. The missing amounts were partially compensated by a positive influx of foreign money in the private sector (sky blue bars). The divergence returned in June 2014 when Mr. Draghi launched the new T-LTROs in an effort to revive the sluggish Eurozone credit growth. In March 2015, PSPP’s launch accelerated the growth of ECB assets and had widened the spread between Target2 net balances.

New money flows (TLTROs loans and revenues from the selling of government bonds) reached Eurozone banks but only partially were employed to increase the exposure on national government bonds. A new source of capital flows has emerged and become the primary driver of Italy Target2 negative net balance: a shift in Italy’s private non-banking sector from government and banking bonds to foreign shares and mutual funds.  Looking closer at Figure 6, one can infer that the Target2 net balance (blue line) was only affected by the sell-off and the subsequent repurchase of Italian government bonds (green line) until June 2014. Afterward, foreign investment by the non-banking sector (red line) played a larger role in dragging down the Target2 balance. Moreover, the last few months of decline could be attributed to a renewed – albeit moderate – flight from government bonds.

Figure 6.

As of the beginning of 2016, over € 180 billion has shifted from Italy towards mutual funds located in Luxembourg, Netherlands and Germany. Only 20% of them can be traced back to Italian entities (i.e. round trip funds). The hunt for yield in a unprecedently low-interest-rate environment can only explain part of this sustained capital flight towards Northern Europe. Subtle but persistent redenomination risk (the risk that a euro asset will be redenominated into a devalued legacy currency after a partial or total Euro break-up) affecting Italian assets. Moreover, the fear of adverse effects of the bail-in regulation that came into effect in January 2016 may have had a meaningful role in explaining this massive portfolio readjustment by the private non-banking sector.
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References and Further Readings:

Publication of TARGET balances (2015) https://www.ecb.europa.eu/pub/pdf/other/eb201506_focus04.en.pdf.

Minenna et al. (2016 - forthcoming) “The Incomplete Currency: The Future of the Euro and Solutions for the Eurozone”, Wiley.

Sinn H.-W., Wollmershäuser T. (2012b), “Target balances and the German financial account in light of the European balance-of-Payments crisis”, CESifo Working Paper No. 4051, December.

Szécsényi P. (2015), “Nature of TARGET2 Imbalances”, https://www.asz.hu/storage/files/files/public-finance-quarterly-articles/2015/a_szecsenyip_2015_3.pdf

Whelan (2012) “TARGET2: Not why Germans should fear a euro breakup”, http://voxeu.org/article/target2-germany-has-bigger-things-worry-about

Whelan K. (2014), TARGET2 and central bank balance sheets, Economic Policy January 2014

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A contrarian perspective on the short euro trade

As the euro continues to drift lower, it has become the accepted wisdom that we are headed for parity with the dollar.

Source: barchart.com

Indeed it is widely expected that the ECB will expand its securities buying program in size, duration and scope (the ECB has been exploring buying municipal bonds for example). The central bank is also expected to cut the benchmark rates, pushing deeper into negative territory. The chart below shows the Euribor futures trading significantly above par as the market expects sharply lower interbank rates.

Source: barchart.com

This of course differs sharply from the monetary policy in the US where markets now assign 70%+ probability of a rate hike next month (as discussed here back in October). There is no question that such divergent policy trajectories should push the euro lower. But has a great deal of this divergence been priced into the markets?

As the Euribor chart (above) shows, the market could now be "priced to perfection". The expectations for a "bazooka" new stimulus from the ECB are also manifested in the record low Eurozone bond yields. For instance, here is Germany's 5-year government bond yield which is clearly pricing in much more demand ahead.

These expectations have resulted in the short euro position becoming a crowded trade once again. The chart below shows speculative accounts' net euro futures positions. What happens if the announcement from the ECB is not quite the "shock and awe" that markets expect?

Source: Investing.com

What could push the ECB to come out with a more modest stimulus increase? Here are some possibilities.

1. In spite of the VW scandal and the Paris attacks, German business sentiment remains strong. The Ifo industrial sentiment exceeded economists' forecasts while the service sector climate hit record highs (below). While the China slowdown certainly created a drag on German GDP growth, the impact has not been as severe as many economists were expecting.

Source: Ifo

2. Moreover, we are seeing significant fiscal stimulus from Germany as the nation's government is addressing the refugee influx.

Source: Deutsche Bank

3. At the Eurozone-wide level we see the composite PMI also beat consensus, touching multi-year highs. The ECB has been known to monitor such PMI indicators.

Source: Markit/Tradingeconomics.com

4. The euro area credit situation is improving, albeit gradually. The deleveraging in the banking system has been over for some time as loan balances continue to grow.

Source: ECB (adjusted for sales and securitization)

We can see signs of stronger bank lending showing up in the Eurozone's broad money supply, which increased more than expected.

Source: Investing.com

5. Finally, the euro area's core CPI rose more than consensus in the latest report. While this is still far from the ECB's target, some central bankers looking at the chart below may want to pause before introducing massive amounts of new stimulus.

Source: Investing.com

This latest core CPI report will therefore increase pressure from some of the more hawkish council members to proceed with a more modest/gradual program when introducing new stimulus.

Jens Weidmann (FT): -  The core inflation rate stands at 1% and should gradually increase towards our definition of price stability, which is – let me remind you – a medium-term concept.

Crucially, the decline in oil prices is more of an economic stimulus for the euro area than a harbinger of deflation.

Lower oil prices reduce energy bills for both households and firms. That frees up financial resources which can then be put to use elsewhere – for consumption, investment or for reducing the debt overhang. All of this is good for the economies of the euro-area countries.

There is no question that the fundamentals for the euro remain bearish, especially vs. the US dollar. However, given some of the trends discussed above, a contrarian approach would suggest more caution on that crowded short euro trade.


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Eurozone reacts to anticipated fed rate hike

Guest post by Marcello Minenna


Almost without warning, the Eurozone government bonds and the Euro experience spikes in volatility this past month. These abrupt movements are clearly correlated with the mayor announcements of a change in monetary policy by, initially by the ECB and then, by the FED. The European banks had been actively pursuing front-running strategies which try to anticipate ECB's moves until the beginning of Quantitative Easing program (PSPP). Not always with success, as experienced with the “flash crash” of April and June. The new game plan spectacularly backfired with the hawkish statement of Ms. Yellen during the FOMC of the 28th of October. This igniting a massive sell-off of Eurozone bonds with an intensity comparable to the previous “flash crashes”.

At the October 22 meeting, Draghi has clearly anticipated an acceleration of the monetary easing policies. He hinted at cutting the deposit facility rate (now at -0.2%) by at least 10 basis points and at increasing the pace of asset purchases. Finally, the ECB strongly suggested that the PSPP program may be extended for another 6 months. Both policy moves were designed to counter a strengthening Euro.

Figure 1.

In August it has become apparent to the European policy makers that a stronger Euro was having an adverse effect on the Eurozone’s balance of trade (Figure 2), thus harming the export driven recovery envisioned by the ECB.

Figure 2.

Since a rising currency was not seen then with favor by the ECB, the market began to evaluate a further monetary easing by the ECB as very likely, especially a reduction of the ECB deposit facility rate. This, in turn, resulted in the European banks resuming their hoarding of government bonds and pushing yields to very low levels in the following month. Even issues characterized by negative rates slipped below the deposit facility rate (Figure 3) thus becoming ineligible for the ECB purchase under the PSPP.

Figure 3.

This buying behavior would have made sense only if banks were expecting an interest rate cut. In fact, only bonds with a yield higher that the deposit facility rate are eligible for PSPP purchases: by lowering the deposit rate, the ECB is automatically widening the pool of purchasable bonds. In this scenario, the owner of the now eligible bonds would have been in the best position to exploit the jump in the value that one should expect due to the increased demand, as the ECB steps in.

Evidently, the chance of a rate cut was in the air. After the Draghi declarations, markets experienced a manic buying that has depressed yields to deep negative levels never experienced before (Figure 4 and Figure 5).

Figure 4.

Figure 5.

Clearly traders were pricing in the hinted cut of at least 10-15 basis points and were taking long positions on the short part of the Eurozone government term structures. The EUR / USD weakened accordingly, down of 20 pips.

Then, something happened that European banks were not expecting . At the FOMC meeting of 28th of October, MS Yellen released a hawkish view; expectations of a rate hike were brought forward to December. This can be easily appreciated by looking at the probability of a rate rise as inferred from the Futures' Prices on FED Funds (Figure 6). In a single day, the odds of a rate hike surged from 35% to 50%.

Figure 6.

This sudden reversal, from the previous FOMC meeting in September, had a clear impact on both the Euro and the ECB interest rate policy. The EUR / USD slipped another 20 bps; almost, instantaneously, the currency fell below the threshold of 1.1. This renewed trend towards a weaker Euro (-7% in two weeks, Figure 7) has unintended consequences for the front-running strategy of European banks: in fact less pressures on the exchange rate have given immediately more room to the ECB to delay or partially scrap the idea of a “QE on steroids”. Suddenly, the strategy of storing ineligible bonds with deep negative rates to front-run the future (but not so certain anymore) deposit rate cut was no longer attractive to Eurozone banks. A selling spree ensued immediately after Ms. Yellen’s speech.

Figure 7.

This pattern was further reinforced after the release of the stronger than expected data on unemployment and payrolls in the US for October. Traders adopted a 70% probability of a US rate hike in December. Predictably, the EUR / USD took another hit downwards of almost 20 bps. The sell-off of Eurozone bonds with negative yields accelerated in the following days (Figure 8).

Figure 8.

What will be the probable dynamics of the Eurozone government bonds in the coming weeks? As the ECB proceeds with the QE program, the pool of eligible assets will continue to shrink at a rapid pace; it’s not a case that the ECB is considering for purchases also municipal bonds issued by the main European cities. The illiquidity of a contracting market and the ever-changing expectations about the delivery of a QE 2.0 will surely put Eurozone bonds under further stress in the coming weeks.


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Bank of Greece expulsion from the Eurosystem could be especially damaging to the currency union

Risks to the euro area's ongoing economic recovery have risen recently as Greece once again takes center stage. The nation is about to become the first developed economy to default on its IMF obligation (joining countries such as Sudan and Iraq). Such outcome may also ultimately result in its exit from the EMU.

Reuters: - Cut off from markets and refusing so far to accept the terms set by its lenders, the Greek government may have to choose in the next few weeks to pay salaries and pensions or repay International Monetary Fund loans.

Its official creditors - the euro zone and the IMF - have frozen bailout aid until the new leftist-led government in Athens reaches agreement on a comprehensive package of reforms.

A deal had been pencilled in for an April 24 meeting of euro zone finance ministers in Riga, but it now seems too ambitious, officials said.

That has raised fears the Greek government will not be able to make its next payments to the IMF, which total some $1 billion over the next month. Missing an IMF payment could mean default and, eventually, an exit from the euro zone.

The fiscal situation in Greece has become untenable, with tax revenue collapsing and government cash position barely sufficient to pay government employees and cover pension obligations through the end of the month.

Reuters: - Greece will need to tap all the remaining cash reserves across its public sector -- a total of 2 billion euros -- to pay civil service wages and pensions at the end of the month, according to finance ministry officials.

Barring a last-ditch deal with its creditors, that is likely to leave no money to repay the International Monetary Fund almost 1 billion euros due in the first half of May, although Greece has said it wants to honor its debt obligations. Athens' scramble for basic funds shows how extreme the financial constraints on Greek Prime Minister Alexis Tsipras have become as he tries to convince skeptical foreign creditors to extend his country new financial aid.

Will we see a last minute compromise? Perhaps. But the Eurogroup is experiencing what many dealmakers would categorize as "deal fatigue" - the motivation to find an emergency solution is no longer there. Moreover, the political climate does not favor a compromise with Greece. While the focus has been on Germany, it is the smaller nations such as Slovenia that have argued vehemently that Greece must comply with the original bailout terms. Slovenia, who struggled through the downturn, cutting pay and shrinking expenditures, views Greece as using the bailout funds for pay increases - and then asking for debt forgiveness. Slovenia's taxpayers whose pensions are considerably lower than those in Greece will not look favorably upon such action.

The Slovenia Times: - Our exposure to Greece is 2.7% of GDP, which was in a year after we had a 8% fall in GDP and when we had to slash pay and economise in all areas."

This is why Slovenia will insist on Greece continuing with the restructuring and continuing to meet its obligations to Slovenia as well as international institutions, [Slovenia's Finance Minister Dušan] Mramor said.

"Given such an exposure Slovenia has toward Greece and such solidarity we provided, Greece has said it plans to raise pensions, raise pay, make employments in the public sector and demand an extra cut it its liabilities to Slovenia, while in Slovenia we are slashing pay and economising in all areas," Mramor said.

With little political will to provide additional financing, what happens after the IMF default by Greece? According to Bank of America, "it would trigger a parallel default to the Eurozone bail-out fund (EFSF) under the legal master agreement, and might force the EFSF to cancel its loan packages and demand immediate repayment. This in turn would trigger a default on Greek government bonds issued under the bail-out accord."

The markets are pricing the probability of default as a near certainty at this point, with credit default swap spreads blowing out.

Greek 5-yr and 1-yr sovereign CDS spreads (source: Barclays Research)

The Greek sovereign debt yield curve has inverted further, with the 2-year yield now above 25%.

It is not at all clear what will happen after the default, but the so-called Grexit becomes increasingly likely. Most analysts now believe that unlike in 2012 the Eurozone will be able to weather this storm due to its better capitalized banks, the ongoing quantitative easing by the ECB (coupled with other measures such as TLTRO), well established bailout mechanism (the ESM), and the OMT backstop facility designed to allow the ECB to support any state that is having liquidity problems. The Eurozone should be able to absorb the losses on some €330bn government exposure to Greek public debt.

French Finance Minister Michel Sapin (via Reuters): - "We have learned to build walls to protect ourselves, to protect the banking system, to protect other countries which could become fragile, if something happens in Greece. So Europe is much stronger. Europe has sheltered itself from turbulence. The danger is for Greece."

However, as discussed before, the nation's divorce from the European Monetary Union will be complex and fraught with more uncertainty than many realize. It's not just about Greece defaulting on on the public debt but also about extracting the Bank of Greece from the Eurosystem. By the time Greece imposes capital controls - which seems increasingly likely - the run on Greek banks will have taken its toll. Deposits have already declined sharply since late last year.

Source: Barclays Research

The Greek banks are replacing these lost deposits with emergency funds (ELA) from the Bank of Greece, who is in turn borrowing from the Eurosystem via TARGET2. With these banks increasingly dependent on central bank support, valuations are collapsing as the need for more bailouts becomes clear. This is especially the case if Greece defaults on its bonds which are widely held by Greek banks.

Greek banks share index

So if the Bank of Greece is borrowing, who is doing the lending? The funds come from the other euro area central banks (via the Eurosystem), particularly the Bundesbank. We can see the increase in this exposure to Greece on Bundesbank's balance sheet. As the Greek citizens are removing funds from their banking system (including taking out bank notes), this balance sheet item at Bundesbank rises further.

Source: the Bundesbank (the latest increase is almost entirely due to Greece)

In a Grexit scenario, as the Bank of Greece is expelled from the Eurosystem, it will default on its TARGET2 obligations. That in turn will force Bundesbank (and other core euro area central banks) to take a write-down. Of course a nation such as Germany should easily absorb such a loss and recapitalize its central bank. But at that point the Germans will surely want to know just how much more of such exposure their central bank holds.

The answer at this point is that nearly 70% of Bundesbank's assets are in TARGET2 claims - a half a trillion euro exposure to periphery nations' central banks. How much support for the EMU will the Germans have once they realize that a large portion of their central bank's assets could be at risk? After Grexit, the TARGET2 exposure will no longer be some abstract concept - the risk levels will become quite real and German politicians and the media will surely drive that point home.

Moreover, as Greece imposes currency controls, depositors in other periphery nations are likely to also begin shifting capital out of their domestic banking system - as they see the writing on the wall. Portugal, Spain, and Italy are particularly vulnerable. Such actions will of course end up increasing TARGET2 imbalances further (as was the case in 2012), putting more of Bundesbank's balance sheet at risk. Contagion could become a major problem again. We already see some early signs, as periphery bond yields rose last week in spite of all the QE buying efforts.

Certainly Grexit related damage can be managed by the national central banks and the European Stability Mechanism. These institutions will be promptly recapitalized. Such actions however will anger citizens of some member states, whose taxpayers' funds will be used to fix the damage caused by Greece. Given the chaos and the political backlash such an outcome will generate, it's unclear when - if at all - confidence in the currency union will be restored. As discussed before (see post), history is not on the Eurozone's side.


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First raw data on ECB QE show asymmetrical purchase patterns; yes, negative rates have a role in it.

Guest post by Marcello Minenna


As the first streams of data related to asset purchases are released by the ECB, we can begin to investigate trying to test different speculative theories that have circulated a lot in the past weeks.

Many words have been spent about the technical feasibility of the €1.1 tln ECB purchase program given that NCBs have to buy €800 bln of government bonds, potentially disrupting those market segments already affected by unbalances. We are referring mainly to the German Bund market, where negative rates up to the long part of yield curve have become the norm in the past three years: actually we observe negative yield for 7 years bonds (Figure 1). Many concerns are related with the potential eligibility of this growing class of debt securities. In fact the ECB has set a limit of -0.2% (equal to the ECB deposit facility rate), thus implying that government bonds with an implicit yield exceeding this threshold cannot be purchased. But also other core countries are potentially affected: France, Finland, Austria, Netherlands. Draghi has recently reassured the market declaring that he does not foresee a scarcity of eligible securities in the medium term.

Figure 1

A general overview of yield structure of the German debt says that over 40% of the negotiable bonds is trading at negative implicit yields; on the same boat we see the little open economies of core Europe and, to a lesser extent, France (Figure 2).

Figure 2

The last available ECB data tells of €32.8 bln of government bonds and €4.92 bln of ESM/EFSF/EIB bonds purchased by the NCBs, while €3.28 bln have been bought directly by the ECB for a total of €41 bln of asset purchased. This corresponds roughly to a mere 4% of the overall program. Despite the thin sample, interesting patterns can already be observed: some obvious, other less. If we look at the bonds purchased that were trading at a negative yield (Figure 3), we obtain a picture fairly correspondent to the scenario represented in Figure 2.

Figure 3

The ranking order of Figure 2 is somewhat respected; what we observe is that the sole starting of the program has driven the yields further in the negative territory, with the appearance of sub-zero yields also on Italian, Irish, Spanish and Slovak bonds. Furthermore, the NCBs seem to be not influenced in their purchase strategy by the increasing quota of bonds in the negative side, since the results of Figure 3 are compatible with a uniform purchase pattern that does not try to avoid negative yields.

In reality, negative rates matter. More complex considerations arise in fact when we decompose the data sample by looking at the maturity of the purchased bond (Figure 4).

Figure 4

It appears that the NCBs are prevalently using two purchase strategies. The most widely used, that we define for this reason the “standard” one provides a dominant quota (a bit higher than 40%) of medium term bonds up to 5 years, a lower quantity of medium-long term bonds hovering between 30% and 40%, and a residual part of long term debt securities that oscillates more but does not go much over 20%. Having considered that the major part of eligible assets are concentrated in the [2-5] years interval, it emerges that the NCBs that are following the standard strategy are purchasing in a uniform, predictable way. The NCBs of peripheral countries and, notably, of Austria and Netherlands are behaving in this regular manner.

Things change for what regards Germany, France and the related group of small continental countries (Slovakia, Finland and Belgium). In fact, these “core” NCBs are implementing a different strategy that sees the purchase of a prevalent quota of medium-long term debt securities (the threshold of 40% is always breached). The level of medium term bonds bought is significantly lower with respect to the other group of central banks, while the quantity of long term bonds swings a lot, clearly playing the role of a residual quantity.

The evidence hence suggests that something is altering the purchase strategy of these NCBs; negative yields have a role, but it seems strictly related to the impact of -0.2% lower limit. In other terms, the NCBs are willing to buy negative yields bonds, but they can only buy until they do not breach the bound imposed by the ECB; in presence of the -0.2% limit, the NCBs are forced to comply with the rules, by shifting to long-dated bonds that are characterized by an higher yield (even if always negative). In this perspective, the potential damage that core NCBs may suffer from negative rates in terms of a reduced flows of interests is not affecting (for now) their purchasing behavior, despite the problem has not yet been addressed by the ECB.

In summary, Bundesbank, Banque of France and the central banks of Finland, Belgium and maybe Slovakia are already suffering the impact of the -0.2% bound, while De Nederlandsche Bank, despite the high share of “sub-zero” bonds bought, is not under pressure to change its purchase strategy. And this is only the beginning: the situation is likely getting worse if we take a glance of the future net issues of debt securities for the Eurozone (Figure 5).

Figure 5

The projections clearly demonstrate the poor supply of core government bonds in the near future that could exacerbate the differentiated behavior of the central banks. In fact, a protracted asymmetry between the NCBs purchase patterns could potentially induce distortions in Eurozone government term structures, by pushing core long term yields lower than peripheral ones. This would imply a widening of spreads that does not appear coherent with the ECB target of restoring Eurozone yields convergence and that cannot be considered a sort of “proper” compensation for the minor profits endured by core NCBs.

In the not so distant future, the ECB may be forced to revise the -0.2% lower bound in order to match the monthly asset purchase target of €60 bln. Time (and data) will tell.


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The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB, Investing.com

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics

Source: Investing.com

Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.

RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.

Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.

Source: Investing.com

But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.

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