The murky world of central banks and private-sector QE

The last 24 hours has seen something of a development in the world of central bank monetary easing which has highlighted an issue I have often warned about. Along the way it has provoked a few jokes along the lines of Poundland should now be 50 pence land or in old money ten shillings. Actually the new issue is related to one that the Bank of England experienced back in 2009 when it was operating what was called the SLS or Special Liquidity Scheme. If you have forgotten what it was I am sure the words “Special” and “Liquidity” have pointed you towards the banking sector and you would be right. The banks got liquidity/cash and in return had to provide collateral which is where the link as because on that road the Bank of England suddenly had to value lots of private-sector assets. Indeed it faced a choice between not giving the banks what they wanted or changing ( loosening) its collateral rules which of course was an easy decision for it. But valuing the new pieces of paper it got proved awkward. From FT Alphaville back then.

Accepting raw loans would also ensure that securities taken in the Bank’s operations have a genuine private sector demand rather than comprising ‘phantom’ securities created only for use in central bank operations.

In other words the Bank of England was concerned it was being done up like a kipper which is rather different from the way it tried to portray things.

Under the terms of the SLS, banks and building societies (hereafter ‘banks’) could, for a fee, swap high-quality mortgage-backed and other securities that had temporarily become illiquid for UK Treasury bills, for a period of up to three years.

Some how “high-quality” securities which to the logically minded was always problematic if you thought about the mortgage situation back then had morphed into a much more worrying “phantom” security.  Indeed as the June 2010 Quarterly Bulletin indicated there was rather a lot of them.

But a large proportion of the securities taken have been created specifically for use as collateral with the Bank by the originator of the underlying assets, and have therefore not been traded in the market. Such ‘own-name’ securities accounted for around 76% of the Bank’s extended collateral (around the peak of usage in January 2009), and form the overwhelming majority of collateral taken in the SLS.

Although you would not believe it from its pronouncements now the Bank of England was very worried about the consequences of this and in my opinion this is why it ended the SLS early. Which was a shame as the scheme had strengths and it ended up with other schemes ( FLS, TFS) as we mull the words “one-off” and “temporarily”. But the fundamental theme here is a central bank having trouble with private-sector assets which in the instance above was always likely to happen with instruments that have “not been traded in the market.”

The ECB and Steinhoff

Central banks can also get into trouble with assets that have been traded in the market. After all if market prices were always correct they would move much less than they do. In particular minds have been focused in the last 24 hours on this development.

The news that Steinhoff’s long-serving CEO Markus Jooste had quit sent the company’s share price into freefall on Wednesday morning. Steinhoff opened more than 60% lower, falling from its overnight close of R45.65 to as low as R17.57.

Overall, Steinhoff’s share price has dropped more than 80% over the past 18 months. The stock peaked at over R90 in June last year.  ( Moneyweb).

According to Reuters today has seen the same drum beat.

By 0748 GMT, the stock had slid 37 percent to 11.05 rand in Johannesburg, adding to a more than 60 percent plunge in the previous session. It was down about 34 percent in Frankfurt where it had had its primary listing since 2015.

You may be wondering how a story which might ( in fact is…) a big deal and scandal arrives at the twin towers of the ECB or European Central Bank. The first is a geographical move as Steinhoff has operations in Europe and two years ago today listed on the Frankfurt stock exchange. I am not sure that Happy Birthday is quite appropriate for investors who have seen the 5 Euros of then fall to 0.77 Euros now.

Next enter a central bank looking to buy private-sector assets and in this instance corporate bonds.

Corporate bonds cumulatively purchased and settled as at 01/12/2017 €129,087 (24/11/2017: €127,690) million.

One of the ( over 1000) holdings is as you have probably already guessed a Steinhoff corporate bond and in particular one which theoretically matures in 2025. I say theoretically because the news flow is so grim that it may in practice be sooner. From FT Alphaville.

German prosecutors say they are investigating whether Steinhoff International inflated its revenue and book value, one day after the global home retailer announced that its longtime chief executive had quit…The investigators are probing whether Steinhoff flattered its numbers by selling intangible assets and partnership shares without disclosing that it had close connections to the buyers. The suspicious sales were in “three-digit million” euros territory each, according to the prosecutors.

In terms of scale then the losses will not be relatively large as the bond size is 800 million Euros which would mean that the ECB would not buy more than 560 million under its 70% limit but it does pose questions.

they have a minimum first-best credit assessment of at least credit quality step 3 (rating of BBB- or equivalent) obtained from an external credit assessment institution

This leaves us mulling what investment grade actually means these days with egg on the face of the ratings agencies yet again. As time has passed I notice that the “high-quality” of the Bank of England has become the investment grade of the ECB.

The next question is simply to wonder what the ECB is doing here? Its claim that buying these bonds helps it achieve its inflation target of 2% per annum is hard to substantiate. What it has created is a bull market in corporate bonds which may help economic activity as for example we have seen negative yields even in some cases at issue. But there are side-effects such as moral hazard where the ECB has driven the price higher helping what appears to be fraudulent activity.

How much?

For those of you wondering about the size of the losses there are some factors we do not know such as the size of the holding. We do know that the ECB bought at a price over 90 which compares to the 58.2 as I type this. Some amelioration comes from the yield but not much as the coupon is 1.875% and of course that assumes it gets paid.

My understanding of how this is split is that 20% is collective and the other 80% is at the risk of the national central bank. So there may well be some fun and games when the Bank of Finland ( h/t Robert Pearson) finally reports on this.

Comment

There is much to consider here. Whilst this is only one corporate bond it does highlight the moral hazard issue of a central bank buying private-sector assets. There is another one to my mind which is that overall the ECB will have a (paper) profit but that is pretty much driven by its own ongoing purchases. This begs the question of what happens when it stops? Should it then fear a sharp reversal of prices it is in the situation described by Coldplay.

Oh no what’s this
A spider web and I’m caught in the middle
So I turn to run
And thought of all the stupid things I’d done.

The same is true of the corporate bond buying of the Bank of England which was on a smaller scale but even so ended up buying bonds from companies with ever weaker links ( Maersk) to the UK economy. Even worse in some ways is the issue of how the Bank of Japan is ploughing into the private-sector via its ever-growing purchases of Japanese shares vis equity ETFs. At the same time we are seeing a rising tide of scandals in Japan mostly around data faking.

Me on Core Finance

http://www.corelondon.tv/will-bond-yields-ever-go-higher/

 

 

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What evidence is there for a bond market bubble?

There is a saying that even a blind squirrel occasionally finds a nut. I am left wondering about this as I note that the former Chair of the US Federal Reserve Alan Greenspan has posted a warning about bond markets. From Bloomberg.

Equity bears hunting for excess in the stock market might be better off worrying about bond prices, Alan Greenspan says. That’s where the actual bubble is, and when it pops, it’ll be bad for everyone.

Actually that is troubling on two counts. The simplest is the existence of extraordinarily high bond prices and low and in some cases negative yields. The next is that fact that his successors in charge of the various central banks may start pumping more monetary easing into this bubble to stop it deflating and it being “bad for everyone”. Indeed maybe this mornings ECB monthly bulletin is already on the case.

Looking ahead, the Governing Council confirmed that a very substantial degree of monetary accommodation is needed for euro area inflation pressures to gradually build up and support headline inflation developments in the medium term.

Let us look at what he actually said.

“By any measure, real long-term interest rates are much too low and therefore unsustainable,” the former Federal Reserve chairman, 91, said in an interview. “When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.”

I find it intriguing that he argues that there is no bubble in stock prices which are far higher than when he thought they were the result of “irrational exuberance” . After all low bond yields must be supporting the share prices of pretty much any stock with a solid dividend in a world where investors are so yield hungry that even index-linked Gilts have been used as such.

What is a bubble?

This is hard to define but involves extreme price rises which are then hard to justify with past metrics or measurement techniques. With convenient timing we have seen a clear demonstration of one only this week as something extraordinary develops. From Sky Sports News.

Sky sources: Neymar agrees 5-year-deal at PSG worth £450m, earning £515,000-a-week after tax. More on SSN.

One sign that we are in the “bubbilicious” zone is that no-one is sure of the exact price as I note others suggesting the deal is £576 million. You could drive the whole London bus fleet through the difference. The next sign is that people immediately assure you that everything is just fine as it is normal. From the BBC.

Mourinho said: “Expensive are the ones who get into a certain level without a certain quality. For £200m, I don’t think [Neymar] is expensive.

To be fair he pointed out that there would however be consequences.

“I think he’s expensive in the fact that now you are going to have more players at £100m, you are going have more players at £80m and more players at £60m. And I think that’s the problem.”

Of course Jose will be relieved that what was previously perceived as a large sum spent on Paul Pogba now looks relatively cheap. Oh and did I say that the numbers get confused?

PSG’s total outlay across the initial five-year deal will come to £400m.

If Sky are correct the high property prices we look at will be no problem as he will earn in a mere 8 months enough to buy the highest price flat they could find in Paris ( £18 million). The rub if there is one is that the price could easily rise if they know he is the buyer!

The comparison with the previous record does give us another clue because if we look at the Paul Pogba transfer it has taken only one year for the previous record to be doubled. That speed and indeed acceleration was seen in both the South Sea Bubble and the Tulip Mania.

Perhaps there was a prescient sign some years ago when the team who has fans who are especially keen on blowing bubbles was on the case. From SkyKaveh.

West Ham were close to signing Neymar from Santos in 2010. Offered £25m but move collapsed when Santos asked for more money

Back to bonds

If we look at market levels then the warning lights flash especially in places where investors are paying to get bonds. If we look at the Euro area then a brief check saw me note that for 2 years yields are negative in Germany, France, Belgium, Italy and Spain. For Germany especially investors can go further out in terms of maturity and get a negative yield. Does that define a bubble on its own as they are paying for something which is supposed to pay you?! There are two additional factors to throw in which is that the real yield situation is even worse as over the next two years inflation looks set to be positive at somewhere between 1% and 2%. Also if we look at Spain with economic growth having been ~3% or so a year for a bit why would you buy a bond at anything like these levels?

Another sign of a bubble that has worked pretty well over time is that you find the Japanese buying it. So I noted this earlier from @liukzilla.

“Japanese Almost Triple Foreign Bond Buying in July” exe: buy or + buy => like a double chocolate pie

Here we do get something of a catch as the issue of foreign investors buying involves the currency as well. Whether that is a sign of the Euro peaking I do not know but in a way it shows another form of looking for yield if you can call a profit a yield. Also there is an issue here of Japanese investors buying foreign bonds not only because there is little or no yield to be found at home but also because the Bank of Japan is soaking up the supply of what there is.

Comment

If we survey the situation we see that prices and yields especially in what we consider to be the first world do show “bubbilicious” signs. If we look at my home country of the UK it seemed extraordinary when the ten-year Gilt yield went below 2% and yet it is now around 1.2%. Of course the Bank of England with its “Sledgehammer” QE a year ago blew so much that it fell briefly to 0.5% in an effort which was a type of financial vandalism as we set yet again assets prioritised over the real economy. What we are not seeing is an acceleration unless perhaps we move to real yields which have dropped as inflation has picked up.

So far I have looked at sovereign bonds but this has also spilled over into corporate bonds especially with central banks buying them. We have seen them issued at negative yields as well which makes us wonder how that all works if one of the companies should ever go bust. Yet we also need to remind ourselves that there are geographical issues as we look around as Africa has double-digit yields in many places and according to Bloomberg buying short dated bonds in the Venezuelan state oil company yields 152% although the ride would not be good for your heart rate.

 

 

The Corporate Bond problem at the Bank of England

It is time to once again lift the lid on the engine of Quantitative Easing especially in the UK. As a I pointed out several weeks ago the ordinary version where sovereign bonds are purchased has reached its target of £435 billion ( to be precise £39 million below). However corporate bond purchases are continuing under this from the August 2016 MPC (Monetary Policy Committee ) Minutes.

the purchase of up to £10 billion of UK corporate bonds

This was to achieve the objectives shown below and the emphasis is mine.

Purchases of corporate bonds could provide somewhat more stimulus than the same amount of gilt purchases. In particular, given that corporate bonds are higher-yielding instruments than government bonds, investors selling corporate debt to the Bank could be more likely to invest the money received in other corporate assets than those selling gilts. In addition, by increasing demand in secondary markets, purchases by the Bank could reduce liquidity premia; and such purchases could stimulate issuance in sterling corporate bond markets.

Okay let me open with the generic issue of whether this is a better version of QE? This starts well if we look at the US Federal Reserve.

The FOMC directed the Desk to purchase $1.25 trillion of agency MBS ( Mortgage Backed Securities)……..The goal of the program was to provide support to mortgage and housing markets and to foster improved conditions in financial markets more generally.

Later it bought some more but here we see a case of a central bank buying assets from the market which was in distress which was a combination of housing and banking. We can see how this had a more direct impact than ordinary QE but applying that to the UK in 2016 has the problem of being years too late unless of course the Bank of England wanted to argue the UK economy was in distress whilst growing solidly in August 2016!

This is a clear change of course from Mark Carney as the previous Governor Baron King of Lothbury was not a fan and whilst the Bank of England had a plan for corporate bond QE in theory in practice it just kicked the ball around for a while and gave up. Why? Well as I have pointed out before the market is small because UK businesses are often international and issue in Euros and US Dollars so that the UK Pound market is reduced. This leads to the Bank of England finding itself having to purchase bonds from foreign companies and this week it is back offering to buy the bonds of the Danish shipping company Maersk.  No doubt it and Danish taxpayers are happy about this but I do hope one day we will get a Working Paper explaining how this boosts the UK economy more than ordinary QE.

The technical view

There are some suggested examples in the Financial Times today from Zoso Davies of Barclays.

Initially, this seemed to work. August and September 2016 witnessed a flurry of new deals in the sterling corporate markets despite the uncertainty created by the UK’s vote to leave the EU. Since then, however, companies’ interest in borrowing in sterling has fallen to levels similar to those seen in 2013 and 2014.

As you can see once the “new toy” effect wore off things seem to have returned to something of a status quo. The “new toy” effect was exacerbated because the borrowing was so cheap.

Borrowers have also benefited from somewhat better terms on their bonds. After the initial announcement, sterling credit spreads (the additional yield risk borrowers must pay relative to the UK government to borrow in sterling) came down sharply.

If we look back we see that not only did the UK ten-year Gilt yield drop towards 0.5% but the spread above it corporate bond issuers had to pay fell, so there was a clear incentive to borrow. The catch is that if we recall the “lost decade(s)” experience of Japan the link between that and productivity activity tends to fail. One rather revealing fact is that the article does not mention real economy benefits at all instead we get this.

Our analysis, based on the limited data available for corporate bond markets, suggests that trading activity has not picked up across the sterling market as a whole, implying that the Bank of England has been crowding out other market participants. That said, the evidence is far from convincing in either direction.

The price effect did not last either.

Since then, however, the sterling market has hardly moved, indicating that most of the market impact came from the announcement rather than their execution. And that lack of movement has been a marked underperformance versus dollar and euro credit markets, to the extent that sterling has returned to being a relatively expensive bond market in which to raise financing.

Of course we have a tangled web here because one of the factors at play is the the 208 billion Euro corporate bond purchases of the ECB have allowed some companies to be paid to borrow, or if you prefer issue at negative yields. This is from Bloomberg in January.

Henkel AG’s two-year note issued at a negative yield

Also its activities make us again wonder who benefits? From Credit Market Daily.

A big theme in 2015-16 was the amount US domiciled corporates funded in the euro-denominated debt markets. As shown in the chart above, it was a record 26% of the total volume in 2015 and 22% in 2016. Low rates everywhere, but lower in Europe along with low spreads made it attractive for US corporates to borrow in euros (even when swapped back to dollars)

So the Bank of England is supporting European corporates and the ECB US ones? Time for Kylie.

I’m spinning around
Move out of my way

The article ends with some points that pose all sorts of moral hazards.

If sterling corporate bond issuance collapses and secondary market volumes plummet, it will be clear that the Bank’s newest tool has been propping up this small corner of the fixed-income universe over the past six months. Conversely, the more graceful the exit from corporate bond buying, the less clear it will be that the CBPS has been much more than a placebo for markets.

So if borrowers want to borrow cheaply just go on an issuers strike? Also what if the lower yields have sent other buyers away and crowded them out? That would have created quite a mess.

Comment

There are a lot of issues here. Lets us look at the real economy where are the arguments that it has benefited? Whereas on the other side of the coin we can see that subsidising larger companies both ossifies the economy and would help stop what is called “creative destruction”. Whilst the productivity problem began before this program started is it yet another brick in the wall for it via the routes just described? As the Bank Underground blog puts it.

Since 2008, aggregate productivity performance in the UK has been substantially worse than in the preceding eight years.

Also whilst the Federal Reserve purchases of MBSs seems to have been a relatively successful version of QE we have to add “so far”. This is in the gap between the word “stop” and “end” as whilst it stopped new purchases it maintains its holdings at US $1.75 trillion. How can it sell these and what if there are losses which could easily be large? Will the Bank of England end up in the same quicksand? Frankly I think it is already in it.

Yes equity markets are higher but the one area in the UK that has surged in response to this extra monetary easing has been unsecured rather than business credit.

 

 

 

The Bank of England continues to extend its policy actions

Yesterday the Bank of England gave its latest policy statement and announcement. The headline announcements were policy was unchanged with Bank Rate remaining at 0.25%, that the £60 billion of government bond would continue and the £10 billion of Corporate Bond QE would begin on the 27th of this month as previously announced. There was an announcement however about another significant policy change.

As set out in the August Report, the Term Funding Scheme (TFS), which had been introduced as part of the policy package in August, would have an initial drawdown period of 18 months.

There will not be votes on this as of course banks need a certainty not available to anyone else! There is in fact also a clear change in the Monetary Policy Committee making this decision.

The MPC only expected to adjust the terms and length of the Scheme should macroeconomic conditions warrant it,

You see this is a type of replacement/addition to the Funding for (Mortgage) Lending Scheme or FLS  which was always announced in this form.

The Bank and HM Treasury launched the Funding for Lending Scheme (FLS) on 13 July 2012.

There has been a widening of the Bank of England’s remit here with little debate or actual announcement. A sort of financial equivalent of what the military call mission creep. Also the FLS has got forgotten by many but it still rolls on with some £60.6 billion of cheap finance provided to various banks of which some £33.1 billion went to Lloyds Banking Group.

Term Funding Scheme

I think that this is an extremely significant move and as it begins on Monday it is time to dig deeper. Here is the main definition.

The Term Funding Scheme (TFS or the Scheme) is designed to reinforce the transmission of Bank Rate cuts to those interest rates actually faced by households and businesses by providing term funding to banks at rates close to Bank Rate.

So cheap funding for banks which of course will put downwards pressure on bank deposit savings rates and presumably mortgage-rates too. Actually the money may be at Bank Rate.

For TFS Groups whose Net Lending over the Reference Period as a whole is positive, the fee will be 0bp per annum.

They can borrow up to this.

The Borrowing Allowance for each TFS Group will be set at 5% of its Base Stock plus an amount equal to its most recent Net Lending amount.

This is badged as being a boost to the economy although I note that the Financial Times spotted another familiar impact.

UK banks have a new funding scheme, as this week’s Bank of England interest rate cut increases pressure on the profitability of financial institutions.

Okay so how much will it boost bank lending to the economy? From the Inflation Report.

The MPC does not expect the TFS to lead to significantly faster aggregate loan growth.

So in essence it is a plan to boost the profits of the banking sector although I would not be surprised if like the FLS there is an impact on mortgage-rates. However even there we saw from the evidence of Switzerland yesterday that there appears to be something of a base for them even if official interest-rates go negative.

I shall watch this space for Monday.

Corporate Bond QE

There have been stirrings on this front and I would just like to remind readers of my analysis of this subject from the 23rd of August.

In essence this is yet another central banking program which helps larger businesses and in particular ones large enough to issue corporate bonds. Smaller and medium-sized businesses may reasonably feel that they have been left out again. If you think about it there will be an effect to ossify the financial system and the economy as larger companies which do not do well may simply issue corporate bonds and carry on regardless.

The news on this subject has gone down that line as this from the Financial Times indicates. From a reply by northshore.

Amgen, Maersk, Apple, AT&T, BASF, BMW, Bouygues, Cargill, Saint-Gobain, Daimler AG, Deutsche Bahn, Deutsche Telekom, Dong Energy, E.ON, Eastern Power Networks (Cheung Kong), EDF, Electricty North West (Colonial First State & JPMorgan), Engie, Eversholt, General Electric, Hutchison Whampoa, IBM, Linde, London power Networks (Cheung Kong), LVMH, McDonald’s, Mondelez, Nestle, Northern Gas Networks (Cheung Kong), Northern Powergrid (Berkshire Hathaway), Northumbrian Water (Cheung Kong), Paccar, Pepsico, Pfizer, Procter & Gamble, Roche, Scottish Power (Iberdrola), Siemens, South East power Networks (Cheung Kong), Suez, Thames Water (Macquarie), Total, Toyota, UPS, Vattenfall, Veolia, Verizon, Wales & West Utilities (Cheung Kong), Wal-Mart, Wessex Water (YTL Corp), Western Power Distribution (PPL).

We find that along the lines of my analysis big businesses are potentially benefiting here as we mull this supposed aim of the scheme.

firms making a material contribution to the UK economy,

There are a lot of issues here so let me run through them. The first is that as I pointed out above not only does the concept support big business but so does the definition. We now have an idea of how this will play out and smaller businesses may wonder what is going on especially if they have to compete with subsidised  larger businesses.

The Bank of England is already cheerleading for the results.

The inclusion of a Corporate Bond Purchase Scheme in the package had been less anticipated by market participants. Consistent with this, corporate bond spreads had narrowed and sterling issuance by UK-domiciled firms had been strong.

The use of the word domiciled will raise a wry smile from those who have ever looked at the economic situation in Ireland and the chasm between GDP and GNP there.

Also the next bit makes you wonder about the next step planned?

Equity prices had also risen.

Comment

There are obvious issues with both these schemes which lead to the danger of what the Cranberries called “Zombie, Zombie,Zombie”. There are a lot of similarities with the mistakes that Japan made where the schemes that were supposed to provide stimulus in fact just channeled cheap cash to big business and led to the “lost decade” concept.

Meanwhile yesterday’s minutes gave us another clue to how Forward Guidance mark 24 is going.

since the August Inflation Report, a number of indicators of near-term economic activity have been somewhat stronger than expected. The Committee now expect less of a slowing in UK GDP growth in the second half of 2016.

So this is good in that the UK economy does not seem to have had a sharp slow down but for the Bank of England there is the issue of it looking like it panicked last month. Is a “sledgehammer” appropriate for a growth slow down?

Overall, these data were consistent with somewhat less of a slowing in near-term UK GDP growth than envisaged in the August Inflation Report.

In essence economic growth of 0.3% is now expected this quarter rather than the 0.1% previously. Yet in spite of the fact that Forward Guidance was wrong again we are promised yet more micro management of the UK economy.

a majority of members expect to support a further cut in Bank Rate to its effective lower bound at one of the MPC’s forthcoming meetings during the course of this year. The MPC currently judges this bound to be close to, but a little above, zero.

The same lower bound that Governor Mark Carney had previously told us was 0.5%.

BBC Radio 4

Tomorrow I will be on the Money Box program debating Bank of England policy with Professor Tony Yates who used to work at the Bank of England. The program starts just after Midday and is repeated at 9 pm on Sunday.

The economics of and problems created by corporate bond QE

One of the features of 2016 so far has been the appearance of QE or Quantitative Easing for corporate bonds with the ECB announcing a start in March and the Bank of England announcing a start earlier this month. This was a particular volte-face for the Bank of England which has had both the ability and the authority to purchase Corporate Bonds for some years now but had previously fiddled around in the market as if it was a market maker before abandoning the whole thing. Oh and at least one member of the Riksbank of Sweden is on the case according to Danske Bank Research.

Jochnick getting hot: is she suggesting a end to Govvie QE going into CB’s instead?

What is the rationale behind this?

There are two main routes where this could help the economy. These are via a price mechanism and a quantity one. The price mechanism is via lower corporate bond yields making it cheaper for companies to borrow which in theory will make investments cheaper. The quantity mechanism is that they should be able to issue more corporate bonds ( at lower yields) and that this extra borrowing will allow them to expand and help the economy. So in essence more corporate bonds at cheaper yields will in theory give an economic boost.

The next influence is more prosaic. Other central banks have noticed that the US Federal Reserve bought a lot of private-sector debt and still holds US $1.75 trillion of it and feel that they missed out. Perhaps it achieved a type of holy grail. Copying that is a little awkward as for example the ECB is on its third go at buying the Euro area equivalent ( covered bonds) and would be open to the accusation of being years behind even a johnny come lately. So we have corporate bond purchases which are badged as helping the private sector.

The ECB slaps itself on the back

The ECB has reviewed its own program and declared it to be a success on the two economic grounds I pointed out. First yields.

over the identified period from 10 to 24 March, 11 basis points of the total decline of 16 basis points in the spreads of euro area investment-grade corporate bonds was related to the monetary policy measures announced in March, more specifically the launch of the CSPP.

Then issuance volumes.

While issuance was subdued at the beginning of the year amid elevated financial market uncertainty, it rebounded significantly after the CSPP announcement. Preliminary data  suggest that issuance in the second quarter of 2016 was well above the average seen in previous years.

As of the end of last week the ECB had purchased some 17.8 billion Euros of corporate bonds which compares to a total program size of 1207 billion Euros.

Problems

What economic effects does lower corporate bond yields have?

The first comes as the theory that lower corporate bond yields leads to more investment collides with reality. On the 11th of this month I pointed out that the US Federal Reserve has its doubts.

Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment………Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases.

At this point a few Ivory Towers will be resembling the Dark Tower of Barad-dûr as the Ring of Power goes into Mount Doom. Also if we stay with the issue of lower yields then Euro area taxpayers may be wondering why they are giving subsidies to big businesses in this way?

Yields of the purchased bonds have ranged from around -0.3% to above 3%, with just above 20% of the purchases being made at negative yields above the ECB’s deposit facility rate of -0.4%.

The incentive to make good investments fades if the money to fund it is in effect free or even more so if you are paid to borrow. On this road more debt could lead to a more sclerotic economy with increasing ossification.

What about “phantom securities”?

This is an issue faced by a previous Bank of England program (Special Liquidity Scheme) where is suddenly discovered that some of what it was buying was not what it thought it was. Awkward! Imagine going back to taxpayers and having to explain that you had been made a fool of. I believe that this was the reason the SLS was wound up early. Can history repeat itself? From the Wall Street Journal.

The European Central Bank’s corporate-bond-buying program has stirred so much action in credit markets that some investment banks and companies are creating new debt especially for the central bank to buy.

Apparently there have been two private placements but like when it was giving private briefings to hedge funds the ECB appears not to have a grip on moral hazard.

“Typically there won’t be a prospectus, there won’t be any transparency, there won’t be a press release. It’s all done discreetly,”

What could go wrong?

I wish to be clear that the ECB is unworried by this and has implicitly asked for it to happen so that it can buy more bonds. The catch is that as described in both Goodhart’s Law and the Lucas Critique changing things like this can have bad consequences and destroy the intended economic effect.

There is an example of the Turning Japanese theme here. Back in one of the earlier versions of QE the Bank of Japan decided to offer cheap loans to smaller companies. The money did not reach them but it did reach the subsidiaries of Nissan, Toyota, Sony et al which suddenly sprang up. But these were pure economic and financial transactions divorced from the real economy as those companies were busy making the Bank of Japan look good not looking for investment finance.

Big Business

In essence this is yet another central banking program which helps larger businesses and in particular ones large enough to issue corporate bonds. Smaller and medium-sized businesses may reasonably feel that they have been left out again. If you think about it there will be an effect to ossify the financial system and the economy as larger companies which do not do well may simply issue corporate bonds and carry on regardless. As the Cranberries put it.

In your head
In your head
Zombie zombie zombie
What’s in your head
In your head.
Zombie, zombie, zombie

Bank of England problems

The FT published some thoughts from HSBC on the 4th of this month which pointed out this problem.

For the 29 per cent of finance that UK companies obtain from the bond market, more is issued in dollars than in euros, and more in euros than in sterling. Should the Bank choose corporate bond QE, it is not obvious that sterling corporate bonds would be the most effective choice.

So as we stand corporate bond issuance in sterling is a relatively minor deal as shown below.

There are £285bn sterling investment-grade bonds compared with £1.3tn denominated in euros and £4tn denominated in dollars, according to Dealogic.

That could of course grow although that ignores the issue of the fact that UK companies are often international and may choose to issue bonds in Dollars and Euros to match their risks and use bank lending for sterling risks. Ooops! Oh and are you thinking what I am thinking? Well it would appear that the ECB is.

Foreign companies with headquarters located outside
the euro area have not thus far increased their bond issuance in euro.

I wonder who they mean? But UK companies borrowing in Euros and being subsidised to do so by the ECB seems on the face of it to be a bigger opportunity than going to the Bank of England. (Update 9pm The comment from Noo2 below points out that this is in fact would be more difficult than I have said). Now the exchange rate is much lower even that seems to favour Euro borrowing. Perhaps the clearest sign of a sustained turn for the UK Pound will be UK corporates issuing Euro corporate bonds. Quite a potential can of worms……

Comment

So on the face of it central bankers will be able to point to lower bond yields and more issuance in response to corporate bond QE. However the latter is not going as well as claimed according to the FT.

While the ECB’s own corporate QE initially lured companies to the bond market — €50bn was sold in March, the month after the policy was announced, supply has since waned.

Also if the problem is demand in the economy as opposed to demand for finance then encouraging businesses to follow the “debt is good” mantra is yet another spider’s web for us to be caught in. Yet another boom for the financial economy that fails to reach the real economy.

I have left pension funds to last. They will be hurt by this as yields go lower again and ironically may buy longer-dated bonds if they are issued. So Bank of England QE will have had the effect of switching them from state backed UK Gilts to private-sector corporate bonds. What could go wrong?

Where is the sledgehammer for the real economy? On this road it is Hall and Oates singing to central bankers.

You’re out of touch