ECB’s Market Dilemma: What Happens When Bond Supply Dries Up?

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ECB President Mario Draghi intends to maintain the program, called quantitative easing, through September 2016.

ECB President Mario Draghi intends to maintain the program, called quantitative easing, through September 2016.

Photographer: Martin Leissl/Bloomberg

As the European Central Bank purchases bonds in an effort to stimulate the euro region’s economy, policy makers in Frankfurt face a dilemma: what to do when they run short of securities to buy.

At the current pace, the ECB will gobble up the entire supply of eligible bonds from the European Investment Bank and similar borrowers by March, according to Barclays Plc. A lack of net issuance by euro-region governments is curtailing the availability of securities, and the central bank said recently that purchases of covered bonds are becoming more challenging.

President Mario Draghi intends to maintain the program, called quantitative easing, through September 2016. While 85 percent of economists surveyed by Bloomberg this month said the ECB will continue to meet its target of 60 billion euros ($66 billion) a month, a shortage of assets may require an adjustment to the way it does so.

“The writing is on the wall,” said Jussi Harju, a Frankfurt-based strategist at Barclays. “The shortage of certain assets is likely to require the ECB to react, which could take the form of an expanded list of eligible bonds.”

The ECB has already shown flexibility in its approach to the program. Executive Board member Benoit Coeure said on May 18 that the central bank would increase the pace of bond-buying to counter expected lower liquidity in July and August, a “frontloading” of purchases.

Market Boost

The purchases have worked so far in boosting the bond market. Spanish 10-year yields dropped to a record low of 1.05 percent on March 12, in the first week of ECB buying and as Greece’s talks with creditors became increasingly acrimonious. While the Spanish yield is now 1.98 percent, that’s still less than a third of the euro-era record of 7.75 percent in 2012.

To fulfill its QE goal, the ECB might increase the amount of certain types of bond it can hold.

It will either look to increase an existing purchase limit of 25 percent of each bond issued by so-called supranational borrowers like the European Investment Bank, or do away with the 12 percent allocation such securities can make up of its total public-sector bond buying, according to Barclays.

An ECB spokesman in Frankfurt declined to comment on whether there would be any adjustment.

Covered Bonds

In the covered bond market, where it has limited itself to a maximum of 70 percent of each bond sale, the ECB said in comments released this month that purchases were becoming more difficult. While it bought 108.1 billion euros of the securities since October, purchases of the bonds have been declining since June.

Covered bonds typically have higher ratings and lower yields than unsecured notes because they are guaranteed by the issuer and have a designated pool of assets, such as mortgages and public sector loans, which could be used to meet payments.

The ECB could also be hampered by a dearth of sovereign bonds. Once redemptions are factored in, only Italy, Spain, Ireland, Finland and the Netherlands are forecast to sell more debt than the ECB is due to buy for the rest of this year, according to data compiled by Bloomberg.

“They need to be flexible about what part of the curve they buy and react to market conditions,” said Owen Callan, a Dublin-based fixed-income strategist at Cantor Fitzgerald LP. “With their frontloading of purchases in May-July they have already shown an ability to do that.”

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