Someone at Reuters must be really short Bunds.
One week ago, 2Y German Bunds tumbled after a Reuters report came out, according to which the ECB was looking for ways to lend out more of its huge pile of government debt to avert a freeze in the €5.5 trillion repo market that underpins the financial system, manifesting in the surge in short-term Bunds. The effect of that particular report lasted for all of one day as the market realized that no matter what the ECB does, the collateral shortage is likely to persist.
Fast forward to today, when the same thing happened, only this time, to the long end, when Reuters reported that, in advance of its March 2017 meeting, the ECB was considering sending a “formal signal after its policy meeting next Thursday that the program will eventually end.” As a result, Bund futures quickly slid to session low, dropping ~30 ticks in 10 minutes, on the back of the Reuters report.
In other words, tapering is coming. However, the ECB is not sure what form said tapering will take, especially since the primary message to be delivered is that QE will be extended beyond March, when it was originally scheduled to end, even if it is modestly (or not so modestly) reduced.
Reuters notes that even skeptics of more stimulus on the bank’s Governing Council “have accepted that an extension beyond the current expiry date of March is inevitable given weak underlying inflation and heightened political risk.”
However, the question remains how to structure that extension. According to Reuters, much of the preparatory staff work has focused on a six-month extension at a steady pace of 80 billion euros per month, an option favored by many as growth is sluggish, inflation lacks momentum and political risk from key elections keeps the chances of market volatility high, three sources said.
But some have indicated they would favor an extension at lower volumes, for example nine months at 60 billion euros a month, fearing that a straight extension could make the program appear open-ended, two of the sources said.
A compromise under discussion would be to signal the program’s eventual end, possibly in the bank’s forward guidance, indicating that the purchases cannot be extended indefinitely. Another option is not to specify monthly purchase volumes, essentially making them dependent on economic developments, the sources said, similar to what the BOJ has done with its curve control operation. That would allow the ECB to buy up to 80 billion euros without requiring it to spend the full amount.
“Coupled with the extension, there’s a sense that you need to send a signal, also for the hawks, that we will not be in the QE (quantitative easing) business forever,” one of the sources said. “We’re not talking about tapering. We’re talking about a signal.”
Actually, you are talking about tapering. However, the reason you don’t want to use that word is because when Bernanke uttered it in 2013, it unleashed the infamous Taper Tantrum in the US and globally, leading to a plunge in bond yields.
There is another problem: with the US tightening at a time when demand for US debt will have to stay constant or rise to fund Trump’s fiscal stimulus, it would be up to Japan and Europe to provide the “helicopter money” to fund US economic growth as DB explained. Even a small hint that this is going away, and suddenly the Trump stimulus is looking very shaky.
Sure enough, as Reuters admits, some proponents of the extension fear an ill-timed signal about reduced buying in future could heighten market volatility, potentially undoing some of the benefits of the scheme.
To be sure, it is not a done deal yet:
Extending the asset buys would require the ECB to ease some of its self-imposed restrictions, a sensitive debate as most options on the table raise legal or political concerns, facing varying degrees of opposition within the Governing Council.
Still, ECB President Mario Draghi seemed to dismiss those concerns this week, arguing that the program was sufficiently flexible, suggesting that parameter changes would not stand in the way if policymakers opted for the extension.
However, with a spate of economic and political events in the first two weeks of December, it just may be that a tapering announcement by the ECB is the catalyst that finally blows over the house of cards market that has soared since November 8 on nothing but hope and lack of concrete news.
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