Recap 2015-02-25: On the ECB running out of bonds to buy

Commentary:

There has been a fair bit of commentary recently about how the ECB may not be able to buy all the bonds it wants because they are purchasing more than the net supply. (i.e. gross issuance net of coupons & rolling over of existing debt) Ergo, the thinking goes, EU yield curves will continue to flatten.

IMO, there is a major point missing in this analysis that renders it inaccurate. Specifically, it only looks at one side of the supply / demand balance, and only part of it also. In other words, not only does it ignore the aggregate supply analysis, but it also ignores substitution effects on the demand side. The fact of the matter is that price / yield provides information for market participants to make trade offs. By definition, supply and demand has to balance, so the whole point of price moving is so that neither side is rationed. Put more simply, price / yield changes themselves create and destroy demand / supply.

In fact, we are seeing all those effects playing out already. Here is a limited list:

• EU investors are already flocking to buy USD debt. That is clearly substitution effect at work, and clearly that reduces demand for EUR debt
• EU investors are buying EU equities. It is potentially less comparable to EUR debt than USD debt, but clearly asset allocation away from debt and toward equities reduces demand
• EU sovereign debt issuance duration has been increasing. The EUR iBoxx index, for example, is set to undergo a big duration extension of 0.09 years at the end of the month, well above average. A universe of debt with a longer duration implies more aggregate DV01 supply
• EU corporate debt issuance is picking up. Global corporations with pricing power seem especially interested to issue in EUR
• The EU High Yield market covenants have weakened so much that a consortium of the largest fund managers has written a letter complaining about it. (h/t Danny)

We’ve seen these effects play out many times before. This recent FTA post has some charts that highlight the changing debt universe. Aggregate EUR and USD fixed income outstanding has already doubled from pre crisis levels.

While universe duration extended by roughly 1 year, or 20%:

The bulk of the growth was driven by the US High Grade market, but note how growth really picked up in late 2010 / early 2011, and again starting in late 2012 on.

Now look at this chart of US yields… see what happened in mid 2010 and mid 2012??

Here is a very short list of other instances where ex-ante supply / demand analysis would’ve likely resulted in incorrect market forecasts:

• US yields rose during the first few instances of Fed QE
• US yields fell in 2010 despite the fact that the US budget deficit gapped up to 10% of GDP by the end of 2009 from 1% two years earlier.
• Oil prices

The fact of the matter is, a simple supply / demand analysis only works in controlled conditions, with inelasticity and limited 2nd and 3rd round effects. Liquid assets in developed markets do not exhibit any of those characteristics.

The data on debt growth is fairly clear, in that it lags economic growth. Here is a chart of US commercial loans & leases in white vs the US Industrial Production Index:

Now, to be fair, the EU growth data thus far does not engender much enthusiasm: (loans to corporates in white, EU IP in orange)

But the data in train area quite unambiguously pointing to a growth pick up. I’ll have a bit more to write on this tomorrow.

Notable:

• France Consumer Confidence improved to 92 vs 91 exp and 90 prev
• China HSBC Mfg PMI improved to 50.1 vs 49.5 exp
• Petrobras was lowered two levels to junk by Moody’s last night. Fitch (negative watch) and S&P (stable) still have the company at the lowest investment grade status. Spreads are 35-70 basis points wider this morning.
• Warren Buffett: "We are definitely interested in buying more German companies….Germany is a great market: lots of people, lots of purchasing power and Germans are productive. We also like the regulatory and legal framework.”
• The Eurozone’s chief banking supervisor has warned that the industry may be forced to raise more (and higher quality) equity as control becomes more centralized and national capital rule exceptions get eliminated.

Upcoming:

• Thu: German GfK Consumer Confidence, EU Money Supply, UK GDP, Italy Consumer Confidence, US CPI, Durable Goods, Jobless Claims, Japan Employment, CPI
• Fri: Month End, German CPI, ChicagoPMI, US Pending Home Sales
• Weekend: ChinaMfg PMI, Australia Mfg PMI, New Home Sales, Japan Markit Mfg PMI
• Mon: Italy Mfg PMI, EU Final PMI, UK Mfg PMI, EU Unemployment, CPI estimate, US Personal Income, Canada Mfg PMI, US Markit PMI, ISM, RBA, AU Building Approvals
• Tue: Canada GDP, Australia GDP, Japan Services PMI, China HSBC Services PMI
• Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance