Normally a central bank uses monetary policy as its core tool to try and stimulate or suppress demand. In doing so they are able, to a reasonable extent, to control inflation. Monetary policy includes setting short-term interest rates, although the central bank is unable to set longer-term interest rates – these are set by the market.
Unconventional policies, such as QE, are brought in when conventional policy is insufficient to pursue the mandate of the central bank and they allow central banks to have impact in the markets in areas where they usually do not have much control.
As fixed income investors, understanding central bank policy is at the core of our investment thesis and when that policy is unconventional it becomes doubly important. So let’s look at what the ECB is doing.
We already have interest rates as low as they can go. The conventional policy became unconventional as soon as the base rate became negative in June 2014. Rates were then lowered again to minus 0.2 per cent, solely because the minus 0.1 per cent was not being passed on to the end users by the banks.
Once again, the transmission mechanism of ECB policy was not working. At minus 0.2 per cent the majority of the large clearing banks have now sent out letters notifying investors that their short-term cash balances will be charged 0.2 per cent interest per annum. This is crucial as it moves money out of cash. This is the first portfolio effect.
Imagine yourself as an EU bank treasurer with large cash balances coming in every day that you normally deposit with the ECB. What do you do now? Luckily bank treasurers have flexibility in their mandates, so they can redeploy these proceeds elsewhere; however when using this cash they will have one common goal…that the new investment should be very low risk. This typically means short-dated bonds with as low a capital charge as possible.
The most obvious trade is into EU sovereign bonds, with German bunds at the top of the list. Depending on the nationality of the bank, the treasurer will of course look at a range of other EU government debt too. Consequently, with deposits at minus 20bp, a two or three-year bund at minus 5bp is therefore cheap. As bunds became more expensive, the rest of the EU sovereigns gradually followed, starting with the shortest next best credit and then the next and then eventually they pushed a little further along the yield and credit curves.
Naturally this is not the only option for treasurers, they will have been looking at other assets too, such as highly rated asset-backed securities (ABS).
The same can be applied to EU portfolio managers. What happens when they don’t like the market? Normally they go to cash as a first step, but now with a daily risk management report warning them of the dangers of holding euro cash balances, they too look to find the next best thing. Moving to negative rates was very powerful.
Long-term refinancing operations and targeted longer-term refinancing operations are also very powerful tools, as they ensure that banks ultimately have unlimited liquidity. This liquidity then assists the portfolio effect happening.
Highly rated covered bonds and ABS were also an outlet for the low-risk fixed income trade. As we know, the ECB already has a programme in place to buy these, however the size that they could acquire in the timeframe that they wanted was never going to be enough to make the portfolio shifts that Draghi was targeting. They do though sit perfectly with the other strategies being deployed by the ECB.
The latest move, which includes purchasing eurozone government bonds to the tune of around €40bn (€60bn in total) a month, does achieve that size. We think this buying programme could be in place long after the initial targeted date in September 2016 and by then vast swathes of the risk off parts of fixed income will no longer be available for purchase… and the rest of it will be very low yielding.
The ECB will also have the ability to shape the yield curves through their purchasing, meaning very long-dated low yields as well as near zero (or even less) shorter dated yields. Hence the strong rally so far in longer dated eurozone government bonds.
The ECB’s ‘togetherness’ is not quite mutualisation of debts, but a strong signal nevertheless, hence the credit compression that we are seeing across the EU. Before the sovereign debt crisis there was very little credit spread between eurozone sovereigns, but today there is plenty. Fundamentally we can argue rightly so, but with this signal of intent from the ECB, the pressure for these yields to compress will be very strong. Therefore there will be significant gains to be had from the compression, and they have started already. The 30-year Spanish bond has rallied by 15 points since Thursday!
In short, we expect large parts of the eurozone sovereign market to move to negative yields, a flattening of their yield curves and spread compression within the eurozone sovereign complex. These are all first order effects.
The second order effects are perhaps the most interesting. This is where the scale of the programme is important, because the scale makes the first order effects sizeable and this is what forces the second order.
All of the ECB’s extraordinary policies when taken together have a profound impact on the ‘risk free’ or ‘risk off’ fixed income market. Taking a trillion of the lowest risk fixed income assets out of the market means that the cash has to go somewhere else, and as risk free becomes too expensive, that cash will move.
High quality ABS, covered bonds and investment grade corporates should all see spread compression. All things being equal (and I know they are not!) the moves will be material. We suspect that many investors will jump one step further and buy into high yield in anticipation of the other assets also becoming expensive.
The fact that high yield bonds are the cheapest that they have been since the middle of 2013 will also drive this decision making process. After all, with so much liquidity, the default rate should remain very low indeed, especially in Europe where the much maligned energy sector is so much smaller. Banks should also benefit from this increased liquidity and low default environment, at least in the short to medium term. Longer term it will invariably lead to margin compression and lower earnings, but few are focussing that far ahead.
At the company level, many will now be benefitting from the weaker euro, although we must be wary of such big currency moves. Against the dollar the move is now over 20 per cent; had there not been such a decline in energy prices, one might be forgiven for contemplating the inflation worries that could accompany such a fall in a currency.
In short, the second order effects should be unambiguously positive for credit spreads in 2015, especially as they started the year at levels much higher than they were in mid-2014.
Naturally, we are not suggesting this will happen in a nice straight line, no doubt 2015 will have plenty of further surprises in store, but this portfolio shift that the ECB have set underway should trump many of the smaller road bumps that we would otherwise have encountered.
One last point to mention, are the potential third order effects. We see one of those being inflation, just what the ECB is trying to create. We think it is much too early to judge whether this process will be successful in that regard, but we are also confident that for it to be successful, both the first and second order effects need to be sustained. Hence our focus today on these when it comes to our portfolios’ positioning.
However, 30-year bund yields at 1 per cent suggest that these third order effects will not happen anytime soon… if ever. In the fullness of time, this too must be wrong.
Mark Holman (pictured on page one) is chief executive of TwentyFour Asset Management. The views expressed here are his own.
