Europe's Bond Shortage Means Draghi Is About to Shock the Market

Distorted Bond Markets and Monetary Policy
  • ECB's monthly debt purchases rise by 20 billion euros in April
  • Ten-year bunds headed for biggest quarterly gain since 2011

As European Central Bank Governor Mario Draghi prepares to increase and broaden his bond-buying program, the shrunken market might be in for a shock.

QuickTake Europe's QE Quandary

While policy makers will expand their asset-purchase plan by 20 billion euros ($22.7 billion) a month at the start of April, corporate debt won’t be included until later in the quarter. That’s leaving investors to face even higher demand for government bonds with supply unable to keep up and some of Europe’s biggest banks are predicting yields are headed for even more record lows.

“All of that is going to be in covered bonds, in govvies, in agencies,” Vincent Chaigneau, global head of rates and foreign-exchange strategy at Societe Generale SA in London, said in an interview on Bloomberg Television’s “On The Move” with Guy Johnson. “That’s going to create a shock on supply-demand in Europe.”

The prospect of increased largess from the ECB has pushed government bonds higher, with the yield on German 10-year bunds headed for their biggest quarterly slide in almost five years. They were at 0.15 percent as of 1:08 p.m. London time on Wednesday, about half the level seen after the ECB announced an increase to its quantitative-easing program on March 10.

French bank Societe Generale predicts the bund yield will slide not only to the record low of 0.049 percent posted in April 2015, but to minus 0.05 percent by the end of the next quarter. That’s among the lowest forecasts in a Bloomberg survey, with the median estimate at 0.4 percent.

The drop in yields isn’t confined to Germany. Italy’s 10-year yield dropped to a 12-month low of 1.20 percent on Wednesday while Spain’s five-year note yield slid to a record-low 0.309 percent.

Inflation Target

The ECB cut its main interest rates, announced the increase to QE and revealed a new targeted-loan program earlier this month as it ramped up efforts to boost inflation in the 19-member currency bloc.

A report on Thursday will show consumer prices in the currency zone probably fell for a second month in March, according to economists surveyed by Bloomberg. The rate hasn’t touched policy makers near-2 percent goal since 2013.

The ECB has said it’s confident it has an “adequate” universe of assets to buy. But even when corporate debt purchases start, some investors are skeptical the ECB will be able to purchase sufficient quantities to alleviate pressure on government securities.

Peter Schaffrik, head of European rates strategy at Royal Bank of Canada in London, said the consensus is that officials will be able to buy about 5 billion euros of company bonds, leaving an additional 15 billion euros of government and agency securities to be acquired each month.

“They have to buy more government debt,” said Schaffrik. “Realistically how much can they buy in the corporate market per month?”

Dragging Yields

Officials have also started buying regional government bonds, according to a Bundesbank list of securities that were acquired under the QE program and made available for lending.

Even so, the buying is limited. The roughly 9 billion euros of debt from German Federal states on the list amounts to less than 1 percent of the total German public sector bonds eligible for lending, according to HSBC Holdings Plc analyst Wilson Chin.

Amid increasing demand from central banks, BNP Paribas SA analysts see bond redemptions exceeding the supply of new securities in the euro region by 123 billion euros next month and by 34.4 billion euros in Germany alone.

“It’s a massive drag for yields,” said Patrick Jacq, a senior fixed-income strategist at BNP Paribas SA in Paris. “There could be some concession ahead of auctions, but demand for the paper will be strong and then on the back of auctions the environment will turn very supportive for the government bond market.”