Drifting Towards Extinction

No, not the human race…the European credit market. What happens when the first, last and largest bidder for EU sovereign and corporate bonds starts to leave the market? We are going to find out within the next six months or less.

Last week, following the European Central Bank’s latest Board meeting, President Draghi announced there were no changes in EU monetary policy. In particular, he said that the ECB’s Quantitative Easing program…€60 billion per month in bond purchases…would continue and not be tapered prior to the scheduled end of the program at the end of this year.

Here exactly is what the ECB said in its statement:

Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of €60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. The net purchases are made alongside reinvestments of the principal payments from maturing securities purchased under the asset purchase programme. If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council stands ready to increase the programme in terms of size and/or duration.”

 Confused? You are supposed to be. This is deliberately ambiguous. Here’s why: (1) the QE program has to end because the ECB is coming up against very real limits and actually running out of things to buy; (2) Germany wants the program to end and will challenge its legality if it is extended; but (3) ending the program will panic the market by removing the dominant price-insensitive bid, likely resulting in a massive crash; and (4) ending the program could drive the euro higher and that would severely punish European industry. What is a poor Central Banker to do!

Under the issuer limit, ECB buying cannot exceed a third of a country’s outstanding debt. This limit was required to get Germany on side for the program. Exceeding the limit would open the ECB to the legal challenge that it is financing sovereign deficits and ‘mutualising’ sovereign debt, two actions specifically forbidden by the rules forming the EU. The ECB’s QE is already under review by the European Court of Justice for precisely these issues. Furthermore, the ECB is approaching its purchase limit for several countries, notably Germany, the euro zone’s biggest economy and the ECB’s top critic. Germany is not issuing enough bonds to enable the ECB to continue buying its debt for more than another six months at the current pace.

The ECB has no choice but to taper QE, and soon. Worried about the consequences, the bank stood pat last Thursday, leaving it to its October meeting for the key decision after making more than two trillion euros worth of asset buys.

If I wore a European corporate treasurer’s hat, then I would be issuing debt like there is no tomorrow because there might not be a tomorrow. Would it surprise you to know that’s exactly what’s happening?

Now, you may argue that scaling back (tapering) and then ending QE in the US didn’t cause its bond market to collapse. That’s because the US market is the world’s deepest market, it serves a single country, it uses the world’s reserve currency and it has one central bank standing behind highly liquid commercial banks. Europe has none of these advantages. The ECB is herding a menagerie of European nations with different goals, ambitions and attitudes to debt. They use the euro, a compromise currency that fits no one and the banking system remains highly levered and stuffed with non-performing loans.

ECB bond buying has kept others buying in its wake, thus keeping interest rates artificially low, solely on the basis that buyers couldn’t lose money if the ECB was there. There is no other conceivable explanation for how Italy, with its enormous debt load and poor debt history, has 10-year debt yielding a mere 180 points more than Germany. Artificially low interest rates have played a major role in maintaining the illusion of Italian solvency. When the ECB stops buying, Italian, Spanish and Portuguese rates will soar, putting enormous pressure on the European Union itself. Could that spell the end of the European credit market and even the euro? I think it could dear reader.