ECB’s Bizarro QE Taper May Add To Summer Bond Market Volatility, Citi Says

Last Monday, the ECB’s Benoit Coeure did a funny thing. He told a non-public audience of hedge funds that because markets are usually less liquid in the July-August “lull”, the central bank would be “slightly” front-loading PSPP purchases in May and June.

Perhaps it hadn’t occurred to Coeure the degree to which the market is now completely beholden to central banks or perhaps the idea that flow trumps total stock every time when it comes to central bank liquidity injections is lost on the French economist but whatever the case, he got a valuable lesson in broken markets the following morning when that very material and very non-public information became publicly available and the EURUSD promptly plunged 150 pips.

The reason the market cares so much about what the ECB might have assumed was a fairly benign policy move is that regardless of whether or not the overall size of PSPP has changed, front-loading asset purchases in May and June amounts to an expansion of Q€ and it means that in months when net supply is negative, the market will have to cope with what is effectively a forced taper, something we began discussing just two days after the program got off the ground in March.

Citi’s Matt King has more on what we’ve called the ECB’s “bizarro taper“:

If the ECB had wanted to test the extent to which traders were hanging on their every word, they could hardly have come up with a better experiment than to promise to boost the pace of QE purchases today, only to cut it back during the summer. We reckon that would have been quite sufficient to produce a market reaction by itself, even without the added questions regarding the manner in which the news was released.

Unfortunately what might seem a mere technicality produces very real effects on the trading floor. Yes, the total stock of QE will remain unchanged, and the tweak was supposedly designed to reduce market volatility in the face of significantly lower net government issuance in the summer rather than to add to it. But all our evidence points in practice to it being the flow of purchases which is the main driver of market movements, not the stock. If, as Coeuré said, you are concerned about the rapidity of the market moves, it seems odd, in our view, to give everyone an incentive to get longer today only to sell again tomorrow.

King is referring to the following comment Coeure made at the same event:

“[The] rapidity [of the Bund sell-off] is yet another incident of extreme volatility in global capital markets showing signs of reduced liquidity.”

That is indeed the case, but what seems to have been lost here is that if one is truly worried about dramatic instances of investors suddenly moving into or out of an asset class, one thing you would absolutely not want to do is encourage market timing by suggesting to traders that the central bank bid will vary depending on the month and depending on supply. 

Nevertheless, that is exactly what Coeure has done, and so once again, we present the following graphic which should prove quite useful in determing what pattern ECB purchases will follow for the remainder of the year:

Or maybe not, because when you’re buying into a fiscal retrenchment, sourcing purchase-eligible sovereign paper is difficult, and so ironically, the ECB’s front-loading efforts, designed to ameliorate an anticipated lack of supply, appear to be complicated by, wait for it… a scarcity of government bonds, because as you can see from the following, the central bank’s holdings of government and agency debt actually grew at their slowest pace in three weeks in the week ended Friday. 

Mission accomplished?