ECB Kills Covered Bond Market; Buyers of Only Resort; Japanization of Europe Continues

ECB president Mario Draghi set out to stimulate bank lending by purchasing covered bonds. Yields plunged, which is precisely what Draghi wanted.

Now, the average covered bond yield of 0.53% is so low that investors won't touch them. Numerous bond deals have been cancelled due to lack of demand. The buyer of only resort is the ECB.

This all transpired since September.

Please consider ECB Blamed for Covered Bond Shortage.

Covered bond supply has reached its lowest level in nearly two decades as the European Central Bank has been accused of crowding out investors from the market by pushing up prices and depressing yields.

European covered bond volumes total $166.2bn for the year to date, the lowest figure since 1996 according to Dealogic. This is in spite of an ECB programme announced in September aiming to stimulate the market.

Last month Allied Irish Banks took the unusual step of postponing a planned 10-year covered bond deal amid market speculation that the yield offered was too low to tempt investors.

“There have been a whole series of deals which have been pulled — not just [the AIB] one,” said a London-based banks analyst. “The ECB is crowding out investors. Covered bond spreads have tightened and real money investors say they are not getting rewarded for the risks they are taking.”

By purchasing covered bonds, the ECB wants to offer additional funding for banks, which, it hopes, will use the cash to boost lending to the real economy.

But amid lower bank funding needs and sluggish economic growth covered bond supply has dried up in traditionally large markets such as Germany. Year-to-date volumes have declined 5 per cent year on year and are less than half the volumes in 2011.

“Buying covered bonds is not the silver bullet that will drive Europe out of the deflationary spiral,” said a London-based debt banker. “It does point towards sovereign QE.”

Japanization of Europe Continues

Economic madness did not help Japan, and it will not cure Europe either. But Central Bankers do not care about losses or failures.

Central bank policy remains: "If it doesn't work, do more of it". And so they will, On December 4, the ECB announced a Broad Stimulus Plan, All Assets but Gold on the Table for Purchase.

ECB President Mario Draghi said that policy makers “won’t tolerate” a prolonged period of low inflation, and that officials discussed “all assets but gold” as potential targets for purchases. The council asked internal committees last month to design new unconventional stimulus measures to help fuel growth and inflation.

Japan issued numerous statements of a similar nature over the past two decades. And after decades of fighting deflation with more debt hoping to spur inflation (an amazingly counterproductive strategy), Japan is caught in a trap of its own making.

Japan wants inflation but it's balance sheet is so bloated that a rise in interest rates of a mere 2% or so would consume 100% of government revenue. No investors would touch Japanese bonds in this setup.

Buyers of Only Resort

The buyer of only resort for Japanese government bonds is the Bank of Japan.

The ECB is on a similar same path. Having cornered covered bonds, the ECB wants to expand the program to other assets.

The Law of Bad Ideas is clearly in play.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com