Benoît Coeuré: Bond scarcity and the European Central Bank's
asset purchase programme
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the Club de Gestion Financière d'Associés en Finance, Paris, 3 April 2017.
* * *
Accompanying slides
I would like to thank Fabian Eser and Niels Krieghoff for their contributions to this speech. I
remain solely responsible for the opinions contained herein.
I am grateful for the opportunity to speak here today at the Club de Gestion Financière.
In my remarks today I would like to address a topic that has received growing attention in recent
months, namely the low level of short-term yields of the euro area's safest sovereign bonds and
their apparent disconnect with those of overnight index swaps (OIS).
On the face of it, this is not the sort of topic that you would choose to discuss over breakfast. But
despite its technical character, I intend to explain that such a disconnect evidences ongoing
structural change in the euro area's bond market and could bear consequences for the
transmission of our monetary policy.
In what follows I will argue that a confluence of factors - some of them of a temporary and some
of them of a more permanent nature - is likely to have contributed to this disconnect. One of
these factors, as I will show, is probably related to the ECB's asset purchase programme (APP),
which raises the legitimate question of whether our purchases hamper the smooth functioning of
financial markets.
My answer today will be that we see no such evidence, but that the Governing Council continues
to monitor very carefully the developments in euro area bond and repo markets.
Let me start with the facts, however.
As you can see on slide 2, OIS rates and German government bond yields with a two-year
maturity have been intimately connected in the past. The reason is that swap dealers tend to use
positions in safe government bonds to hedge interest rate risk on swaps. And with securities
issued by the German government generally perceived as bearing very little credit risk, we would
expect them to be related to swap rates. This is true for all tenors by the way and is not specific
to the two-year rate that I am showing as an example on this slide.
Now, why then have yields of high credit quality bonds - and I refer to German bonds merely for
ease of exposition - why have they gradually decoupled from swap rates since about the middle
of last year?
To facilitate and substantiate my answer, I would first like to show you on slide 3 a chart on the
evolution of the spread between overnight index swaps and German Bunds for the 10-year tenor.
You can see three things here:
first, unlike the two-year tenor, the spread has been relatively stable over the past two years,
although also here we have recently observed a slight downward trend; but the scale and
scope are much more moderate, so this suggests that maturity-specific factors must
currently be at play;
second, you can see that there was a sharp and sudden drop in that spread in January
2015; incidentally, that drop occurred around the announcement of the ECB's APP;
and third, the current level of the 10-year spread is far from being unusual from a historical
perspective; in the summer of 2011, for example, spreads widened sharply on account of a
sudden reversal in risk sentiment that brought the Euro Stoxx 50 down by nearly 30% in a
matter of few weeks.
When we look at these last two episodes, it is probably easy to see that the swap spread - in
one way or another - is likely to be related to differences in the relative supply and demand of
government securities and interest rate swaps. Indeed, the supply of swaps is very ample and
practically only constrained by the amount of credit risk which can be taken by market
participants when entering into these contracts.
Government bonds, by contrast, are in more limited supply. So, when investors pile into
government bonds because they are looking for safe and liquid assets, such as in the summer of
2011, demand temporarily increases, pushing up prices and driving down yields.
Announcements of central bank asset purchase programmes make this point even clearer: the
sharp drop in the swap spread around the announcement of the APP in January 2015 reflected a
re-pricing by investors of the future net supply of Bunds to the market - after the ECB's
purchases - and the associated duration risk to be borne by private investors.
The current situation in the short-term segment of the bond and swap market resembles many of
the aspects I just alluded to. Specifically, we think that the recent spread widening is by and large
the result of a growing supply and demand imbalance that has contributed to the fall in short-term
sovereign bond yields to the low levels we are currently seeing.
In what follows I will discuss in more detail: (i) the factors that we think have contributed to recent
developments and (ii) what they may imply for policy. In doing so, I will also try to explain why we
observed an immediate reaction of the 10-year swap spread to the announcement of the APP,
while movements at the short end only seem to come to the fore as the implementation of the
APP gradually proceeds.
The demand for short-term safe government bonds
I see three main reasons for the growing demand for short-term safe bonds: regulatory factors,
flight to safety as well as the direct and indirect effects of the APP.
In the short run, these factors can all affect market prices if the supply of these bonds is inelastic.
I will come back to this later.
Regulation
Regulation is the first factor that could have contributed to the strong increase in the demand for
1
safe and short-dated assets, although not for the reasons one might think of at first. Regulation,
as you know, does not happen overnight. It is a long and often strenuous process. But in recent
years several new regulations have come into force.
For example, a number of liquidity regulations affecting banks such as the net stable funding ratio
(NSFR) and the liquidity coverage ratio (LCR) require banks to hold a sufficient quantity of
highquality liquid assets. So, it is natural to think that these regulations would bump up demand for
government bonds. But it is not so trivial. Indeed, there is currently well over €1.5 trillion in excess
liquidity in the euro area banking system. And because central bank reserves count as
highquality liquid assets, these regulations are unlikely to be the main driver of demand by banks for
high-quality liquid safe bonds in large quantities. Central bank reserves and very safe government
bonds of short duration are in many ways close substitutes.
By implication, therefore, it seems likely that mainly regulations other than the LCR, the NSFR or
the leverage ratio (LR) have created incentives to hold an increasingly larger share of
government bonds, which in particularly seem to affect actors other than banks.
Solvency II, for example, has made it more attractive for insurers to hold cash-like securities,
such as AAA-rated bonds, rather than holding cash in a bank account.
Also, the mandatory posting of collateral for uncleared derivatives, as governed by the European
Market Infrastructure Regulation (EMIR), entered into force at the beginning of the year, and from
1 March 2017, all in-scope counterparties are obliged to post variation margins with a phased-in
implementation for initial margins from 1 September 2017 through to 1 September 2020.
Collateralising financial transactions that weren't collateralised before will naturally create
additional demand for safe and liquid government bonds. Central counterparty (CCP) data, for
example, suggest that a significant share of assets pledged as collateral for meeting initial
margins consists of government bonds. However, as yields on bonds have fallen relative to the
remuneration on cash, more cash is used for initial margins than used to be the case. This
elasticity of bond collateral is important to bear in mind when trying to assess the impact of
central clearing or bilateral margining of derivatives transactions on collateral demand.
Taken together, regulatory factors can to some extent explain why some investors seem
relatively price-insensitive with regard to their demand for safe short-term government bonds.
This can best be seen by those who do have an economic alternative: euro area banks with
access to the deposit facility. Recall that German three-month and six-month bills currently trade
around -1%, well below the rate on the deposit facility. The fact that banks still hold sovereign
bills strongly points to a non-pecuniary motive.
Flight to safety
Let me now turn to the second factor: flight to safety.
I showed you earlier that it is typical for spreads between swaps and quasi-credit risk free
sovereign bonds to widen on account of risk aversion. As for the summer 2011 case, one would
normally expect such flight to quality to be temporary, with the spread eventually returning to its
pre-crisis level after some time. So flight to quality would tend to amplify, at times, the more
secular trends arising from regulation.
This, however, is not what we have observed recently at the short end of the curve. For example,
after the UK referendum on EU membership in June 2016, the two-year German sovereign
bondOIS widened as investors sought safety in short-term German sovereign bonds or equivalent
safe assets. By the way, swap rates also fell in this instance as markets expected the ECB to
ease its monetary policy stance further. But while OIS rates cheapened again as investors
understood that policy rates would remain unchanged, German sovereign bond yields never
really recovered from the Brexit-induced fall. You can see this on slide 4.
This is puzzling at best, but it could mean that Brexit was merely a catalyst for a more general
re-evaluation by markets of the amount of short-term government bonds available to investors,
possibly related to expectations of central bank purchases or in anticipation of perceived political
risks, such as the US election, which was just a few months away.
Events in recent months also have proved surprisingly persistent. Market intelligence generally
pointed to the re-emergence of perceived political risks in the euro area as a prime reason for the
renewed marked drop in short-term yields of German bonds in February. You can see on slide 5
that this drop indeed coincided with a widening of sovereign credit spreads.
But again, doubts on the importance of the flight-to-safety nature also remain here. For example,
over the most recent period of spread widening, stock markets worldwide rallied, also in those
euro area Member States where political risks are perceived to prevail. Here in France stocks
have gone up by nearly 7% since early February, barely a sign of increased risk aversion.
There are therefore legitimate doubts about whether recent developments in bond markets
reflect a general, widespread flight to safety across different asset classes. Instead, portfolio
rebalancing seems to have been specific to euro area bond markets, with some bond investors
shifting out of markets where political risks are perceived to be large and into traditional safe
haven markets, thereby contributing to a widening of short-term swap spreads.
The direct and indirect effects of the APP
Let me now turn to the ECB's asset purchase programme.
Here it is helpful to distinguish direct effects from the purchases on yields from indirect effects.
Direct effects relate to those effects that can be attributed to the ECB, through its purchases,
reducing directly the amount of short-term bonds available to private investors.
Indirect effects, by contrast, are those that may arise because of the excess liquidity that our
purchases create. You can see this on slide 6.
As I said earlier, euro area banks can, in principle, store their liquidity safely in the ECB's deposit
facility. By contrast, non-euro area banks and other investors have no access to our facilities.
And often they cannot place large amounts of unsecured cash with banks either, due to their risk
control frameworks. As a result, investors without access to the Eurosystem's deposit facility are
typically forced to park excess liquidity in the most liquid and safest available storage facility,
most often in bonds issued by the safest sovereigns. So, these investors tend to be fairly
priceinelastic.
We find evidence for such a mechanism, for instance, in the fact that especially non-euro area
investors are increasingly holding a larger share of bonds issued with an original maturity of up to
two years. You can see on slide 7 that when we started the APP in March 2015, non-euro area
investors were holding around 70% of these bonds - already an appreciable amount. In the third
quarter of last year - the latest available data - they held nearly 90%.
The liquidity holdings by such investors are, of course, not invariant to our asset purchases. After
all, non-euro area residents are large sellers of securities to the Eurosystem. Should they wish to
keep their exposure in euro, they may decide to park, possibly temporarily, the receipts from our
purchases in high credit quality short-term sovereign bonds. Expectations of increasing
longterm interest rates globally may have further contributed to keeping the duration of such liquidity
holdings short, so as to limit exposures to duration risk. This mechanism can thus be considered
an indirect, technical implication of our monetary policy measures.
Moreover, the structure of euro area financial markets implies that business models that typically
attract more holdings of excess liquidity, such as investment banks, clearing and depository
2
institutions and custodians, are predominately located in core euro area countries. Also, the
capacity or willingness of banks in financial centres to accept additional deposits or reserves at
attractive rates might diminish over time as excess liquidity grows.
All this could contribute to a recycling of excess liquidity into government bonds in these
jurisdictions. And these effects might be highly non-linear, as the previous slide 6 suggests. This
also means that establishing a direct, causal relationship between excess liquidity and swap
spreads is inherently difficult.
Let me now turn to the potential direct effects of our asset purchases.
By definition, our asset purchases reduce the amount of assets available in the market. As you
know, the Eurosystem aims to distribute its purchases in a market-neutral manner. However,
before the Governing Council in December decided to allow purchases also below the rate on
our deposit facility, actual purchases of German short-term bonds and of those from other safe
jurisdictions were often limited as bonds tended to trade more expensively.
This suggests that direct effects were likely to have been only of a limited nature throughout most
of the programme. You can also see this from the very loose relationship between our total
purchases of German bonds and the two-year swap spread on the left side of slide 8.
Of course, we cannot rule out that the shift in the maturity composition of our public sector
purchase programme (PSPP) since the removal of the lower floor for purchases - and the
associated change in the market's expectations of the future availability of short-term bonds -
have accelerated the fall in rates at the front end of the curve in recent weeks.
But when we announced on 8 December 2016 that purchases below the deposit facility would in
principle be allowed, the short end of the yield curve, where such purchases could be expected
to be more intense, reacted only little, as you can see on the right side of slide 8, which
compares the German curve shortly before and after the announcement.
So, unlike the announcement effect on the 10-year tenor that I showed you at the beginning, the
announcement of 8 December seemed to contain limited news for investors. This could mean
that investors had already priced in, to a large extent, the possibility that we would allow
purchases below the DFR. Indeed, in the weeks before our 8 December meeting we had seen a
marked widening of the two-year swap spread that you can see if you go back to slide 4. But
because this period coincides with the aftermath of the US election, we cannot be entirely sure if
it was the anticipation of our policies, flight to safety or a combination of both that contributed to
the widening of spreads.
However, what I can rule out is that the intensity of our purchases has played a decisive role on a
day-to-day basis, as the daily purchase amounts have been fairly constant. Interestingly, when
we started purchases of sovereign bonds with yields below the deposit facility rate, yields at the
short end actually increased. Over the past three weeks, too, we have seen short-term yields
increasing despite continued Eurosystem purchases.
The supply of short-term safe government bonds
Let me now briefly turn to the other side of the coin - the supply of safe assets.
Typically, debt management offices have some flexibility in their issuance behaviour. But for
some of them the funding plans are relatively stable. This means that supply often tends to be
inelastic in the short term and a sudden build-up of demand can cause an increase in prices.
Moreover, we have witnessed a more general decline in the supply of safe and liquid government
bonds in recent years that may increasingly put pressure on yields as demand soars. This is
particularly true for bonds with a maturity of less than five years.
There are three factors behind this observation:
First, as you can see on slide 9, the financial crisis has led to a downgrade of several
sovereigns, thereby significantly reducing the quantity of global and euro area bonds rated AAA.
Moreover, the amount of euro area short-term public debt of the highest credit quality is much
smaller, relative to the economic size of the monetary area as measured by GDP, than, for
instance, in the United States.
Second, more recently, net issuance of some AAA-rated sovereigns, such as Germany and the
Netherlands, has been negative. In other words, consolidation of public finances of AAA-rated
sovereigns has led to a gradual decline in the stock of outstanding safe and liquid bonds. This
you can see on slide 10.
And third, because interest rates are at historically low levels, we have also seen sovereigns
shifting issuance towards longer maturities with a view to locking in low financing costs for a
longer period. In Germany, for example, while the share of bonds with maturities between two
and five years accounted for more than 17% of the total outstanding back in 2012, today it
amounts to only 11%.
In sum, we see growing demand chasing declining supply. In this environment, it is not surprising
to see prices go up and yields down. What is important for policymakers, however, is to
understand whether these conditions are likely to prevail and whether they could affect the
transmission of monetary policy or bear risks for financial stability.
Spillovers from the repo market and securities lending
Before I give tentative answers to these questions, allow me to briefly address another market
segment, which is different but related. Historically, not only did safe bond yields and OIS rates
trade closely together, the same was also true for rates on repurchase agreements (repo).
Recently, repo rates, too, have come to trade significantly below OIS rates, which raises the
question of whether repo rates might be contributing to the drop in short-term bond yields.
It is well known that repo markets are widely used for cash market intermediation to finance long
positions and as a means to borrow securities to deliver into short positions. So, at face value,
price actions in one market could spill over to the other. But identifying the direction of spillover is
not always easy.
For example, there is evidence of a spillover from repo markets to bond markets in the US:
declines in the supply of collateral, for example as a result of central bank asset purchase
programmes, lead to a decline in Treasury special collateral rates, which also passes through to
3
Treasury market prices. Interestingly, the authors find that these impacts are larger for
shortterm securities.
So bonds that trade special in the repo market should also trade at a premium in the cash
market. But this is not what we always observe in the euro area.
Indeed, for the euro area it has proven difficult to establish a robust link between developments in
the repo and the cash bond market. Although swap spreads are the largest at the short end of
the curve, Bund specialness in the repo market is concentrated at the medium to long end of the
curve. This is shown on slide 11.
This suggests two things: first, scarcity at the front end of the Bund cash market, as signalled by
the wide swap spread, does not seem to have led to a rise in the specialness premium of
shortdated bonds in the repo market of equal proportion. Second, the specialness of medium to
longterm bonds in the repo market has not translated into a similar spread widening between Bunds
and OIS in the cash market.
One way to make sense of these developments is to look at how bonds are channelled back into
the (repo) market.
For example, it could be that holders of short-term German government bonds - mainly non-euro
area investors, as I mentioned earlier - are generally willing to provide them in sufficient quantity
in the repo market. This might explain why short-term Bunds tend to trade less "special".
At the same time, PSPP purchases in Germany have long been concentrated in medium to
longterm maturities due to the restriction not to conduct purchases below the DFR. As early as April
2015, securities purchased under the PSPP have been made available for lending in a
4
decentralised and cash-neutral manner by Eurosystem central banks.
But I think it is fair to say that the initial restriction on lending bonds only against other securities
was too penalising and is likely to have contributed to the growing specialness premium in that
segment of the yield curve where the Eurosystem was intervening most heavily last year.
The Governing Council's decision of last December to open the facility also for lending against
cash, up to a maximum of €50 billion currently, was therefore an important step towards
alleviating market pressure. We have seen a swift pick-up in the usage of lending against cash
collateral and the requests to borrow securities tend to be concentrated in those ISINs which also
trade "special" in the repo market.
So, over time we would expect that our new cash collateral facility will help reduce tensions. At
the same time, it is no panacea. Our securities lending facilities are generally only available to
banks. That means that non-bank investors that also have a strong demand for short-term
German government bonds are not able to borrow these bonds directly from the Eurosystem.
And bond scarcity due to regulatory constraints and low or negative net supply of bonds has
become a structural, standing feature of this market.
Conclusion
Let me conclude.
We have recently observed a widening of the spread between yields of two-year sovereign bonds
of core jurisdictions and the OIS curve. We think this is likely to reflect a confluence of factors,
namely regulatory factors, flight-to-safety flows as well as the direct and indirect effects of our
purchase programmes.
The relative contributions of each of these components are inherently difficult to assess. But the
combination of growing excess liquidity and the need of investors without access to our deposit
facility to park these holdings in a safe and liquid storage vehicle are likely to have been a
measurable driver of recent developments. The direct impact of the Eurosystem's purchases
below the DFR is probably more limited.
Whether or not these developments should be a source of concern for policymakers depends
largely on how persistent these effects will likely prove, as well as their implications for market
functioning, and ultimately the transmission of monetary policy. Temporary blips can be safely
ignored. But a silent and lasting decoupling of the short end of sovereign curves from our key
policy rates warrants close monitoring by policymakers.
For monetary policy, the prevailing financial conditions should remain consistent, as they have
been so far, with the monetary policy stance intended by the Governing Council. For financial
stability, very depressed funding rates may incentivise sovereign bond holders to engage in more
risk-taking, and banks to tilt their funding structures towards less stable wholesale funding.
These risks have not materialised so far. Now, how likely are they to materialise? In other words,
how persistent could current conditions prove?
Some factors, such as regulatory demand for safe assets, are of a structural nature. They can
be expected to persist. Other factors, which have driven short-term sovereign bond yield to
record lows, are likely to be of a more temporary nature. In this regard, there is hope that the
perceived political uncertainty, which has triggered flight-to-quality flows, will gradually dissipate
and that investors rebalance their short-term fixed income again towards other bond markets.
To the extent that our asset purchases have contributed to this development, the reduction of our
monthly purchase pace from €80 billion to €60 billion as of today will provide some relief. At the
same time, increasing liquidity in the hands of investors without access to the deposit facility will
continue creating demand for safe assets. For the time being, these factors are therefore likely to
continue exerting a certain degree of downward pressure on short-term bond yields.
What I can say with reasonable confidence today is that, as I suggested at the beginning of my
remarks, so far we see no evidence that the current constellation of interest rates bears risks for
the smooth functioning of markets, nor to financial stability or the transmission of our policy.
The Governing Council will continue to monitor carefully these developments.
Thank you for your attention.
1
See also CGFS (2013), "Asset encumbrance, financial reform and the demand for collateral assets", Report
submitted by a Working Group established by the Committee on the Global Financial System, Paper No 49.
2
Germany's role as a financial centre pre-dates the financial crisis. See, for example, Cabral, I., F. Dierick and J.
Vesala (2002), "Banking integration in the euro area", ECB Occasional Paper Series, No 6.
3
See d'Amico, S., Fan, R. and Kitsul, Y. (2014). "The scarcity value of Treasury collateral: Repo market effects of
security-specific supply and demand factors", Finance and Economics Discussion Series Paper No. 2014-60.
4
See Securities lending of holdings under the expanded asset purchase programme (APP) .