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The end of the purchase programme: Economics 101

24 September 2017
Richard Kemmish

Maybe we should hold our biggest annual conference in Barcelona every year. Something about being there makes delegates strangely upbeat in a way that – with all due respect to Dusseldorf – some venues don’t.

In particular I thought that we were all very relaxed about the end of the purchase programme. According to an online poll only 8% of people are in full Dusseldorf mode and thought that the end of the programme would cause a ‘significant sell-off’, compared to a huge 80% having a Barcelonic ‘nothing to worry about’ attitude.
To decide who I agreed with I started to think of the problem in classical economic terms. We have reached the current (dare I say, crazy) spread environment for covered bonds mainly because of one very large, very obvious and price insensitive source of demand.

But looking at the granularity and over-subscription of order books of many recent transactions (and looking at the number of investors who bothered to turn up in Barcelona) it looks like it isn’t just the ECB who are price insensitive. Spreads have tightened enormously and a lot of investors are still playing, perhaps with a smaller ticket size, but still playing.

If demand is price insensitive on the tightening it is presumably price insensitive when spreads widen. Which suggests that a much bigger price move will be needed to substitute private sector investors for the ECB.
Price insensitivity
The idea of price insensitivity fits in with the idea that much of the remaining demand for covered bonds is structural – we buy covered bonds because we need to. If that is true – for example, because we have liquidity buckets to fill, or collateral to post, only a fundamental shift in price relative to the other asset classes that might fulfil the same role (govvies and agencies) will significantly change the level of demand. With the purchase programme likely to end more or less simultaneously in all asset classes this is unlikely to be the case.

Not all are forced to buy, I spoke to investors in Barcelona who have stopped buying (which does beg the question of how they justified coming to Barcelona to their bosses and spouses). Is their return to the market in response to a spread widening symmetrical to their leaving in response to spread tightening?

Probably not. In practice being ‘forced down the credit curve’ means doing the work necessary to open credit lines. When that work is done, that credit committee satisfied, it is difficult to then justify a return to the safer, more expensive asset class just because of a widening of spreads. That is particularly the case when you have only run as far as senior preferred securities – the most obvious ‘next asset class in line’ after covered bonds. As long as they are available and offer a spread pick-up over covered bonds it will be more difficult to switch back to covered bonds than it was to switch out of them.
All of which suggests relative price insensitivity of demand. In my next post: supply.

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