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Should you be scared of the great unwind?

31 July 2017
Richard Kemmish

Looking at the numbers rather than the words, it seems that the ECB has already started to taper its covered bond purchase programme. Whatever the future for quantitative easing in total, the covered bond market appears to have done its bit for now. Last month’s covered bond purchases were ‘only’ €3.5bn.

The Fed - half an economic cycle ahead of us - is already grappling with the idea of how to reduce its balance sheet to ‘normal’ levels. This may or may not be necessary for the normal functioning of the economy but – like a return to equilibrium interest rates - is certainly necessary in order to give central banks capacity to deal with the next crisis.

One day the ECB will have to do the same. Presumably selling the bonds would be too disruptive so this is likely to manifest as not reinvesting maturing bonds. Even that might be too aggressive – perhaps only reinvesting 50% of each maturing bond?

Should we live in fear of that day? I think not.

Firstly, perhaps most importantly, the ECB ain’t stupid. They monitor the market closely and are acutely aware of the market disruption risks if they get the great unwind wrong. Most likely their behaviour will be ruled by that – slightly contradictory – combination of factors that central banks are so brilliant at: clear communication of objectives and flexibility.

Also, they have the not insignificant advantage of watching the Fed unwind its balance sheet first and learning from its experience.
Secondly, technicals are going to be very supportive of the unwind. The market clearly needs more sellers, fewer buyers in order to return to normality (which is arguably another way of saying that the market is over-due a correction after the purchase programme’s distortion).

I also suspect that the technicals are going to get even more supportive for reasons unrelated to the purchase programme. The current buy/sell imbalance is going to be supported from the sell side – in particular less covered bond issuance to make way for more loss absorbing senior debt and revitalised securitisations –and the buy side - more technical buying for liquidity and collateral buffers.

Finally, if we do see significant spread widening in covered bonds as a result of the unwind, the effects can be ameliorated by greater use of the ECB’s repo operations. The days of central bank term repo operations attempting to nationalise the debt capital markets may be over, but like methadone for heroin addicts, it could certainly help overcome the withdrawal symptoms.

So yes, I am optimistic that the normalisation of central bank covered bond holdings can be done in a way that won’t cause un-due market disruption. Now is not the time to start the process but, just as you don’t want to wait until you are sick before registering with a doctor - now might be a good time to start to talk about the modalities of the process.

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