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How will it all end?

07 October 2016
Richard Kemmish


“This is the way the world ends; not with a bang but a whimper” – T.S. Eliot

The ECB’s covered bond purchase programme was the biggest topic of discussion - or should I say complaint? - at the recent Euromoney Covered Bond Conference. But naturally, for all of the complaints the ECB didn’t change anything about their programme. They already knew about the impact they were having on yields, liquidity and price distortion. But it’s a necessary evil.

But for all of the discussion of the implications and debates about when it will end it seems that there is relatively little discussion of how it will end. Which is both hugely unknown and hugely important. Let me count the ways:

The ECB could just stop buying covered bonds and buy other securities instead. It seems unlikely that the other securities will be any of the existing sectors, public sector, corporates or securitisations, all of whom have credit, practical or legal impediments to their ability to take up the slack.

Could the ECB buy bank unsecured bonds? If they did it would reduce the relative value distortion between senior and covered and, as a result, likely supply of the two products. More spread, less covered bonds. But buying unsecured bank bonds creates huge political and credit implications for the ECB. Would they buy bail-in-able debt? Would it be perceived as back-door state aid for weak banks?

Would the ECB stop buying suddenly, as they did with the first purchase programme? Or would the purchases just wither away over time to nothing? the way that the second purchase programme did.

In the first case, would that be pre-announced, again as with the first purchase programme, or just happen suddenly? The problem with the pre-announcement is that it would encourage pre-funding, a burst of activity followed by a long quiet period. To some extent we saw that with the first purchase programme.

If it is a more sudden announcement, it will cause volatility.  Although a sudden end to the covered bond element of QE is a source of local volatility rather than the macro volatility that we saw when the Fed announced that they would be tapering their entire QE programme.

Which leads on to the next major distinction – the end of QE itself. Possibly the signal effect (we don’t need QE anymore) will counterbalance the implications (they’ve stopped buying bonds). Too big a topic for here but it has to happen one day and I guarantee it will be an interesting one.

Finally, what happens afterwards? I doubt that the ECB will ever get around to selling their bonds but they will have to decide whether the portfolio amortises away naturally, whether proceeds are reinvested to keep their balance sheet constant or something in between these two extremes.

The purchase programme is by far the biggest factor in our market, it must end one day and we have absolutely no idea how it will end or what the implications will be.

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