Our Global Fixed Income Strategy service estimates that the flow of new Treasurys, JGBs and Eurozone Bonds to the private sector will contract by an average of almost €200 billion in 2015 and 2016.
The stock of bonds from these key issuers will be shrinking at a time when regulatory pressures continue to boost the demand for high-quality government paper. The size and composition of the Eurozone sovereign bond market make the supply/demand mismatch even more pronounced:
- The stock of AAA-rated government bonds is 15% of GDP in the euro area, far below the equivalent ratio in the U.S. of more than 50% when the Fed began QE3. This suggests that the scarcity premium will be even greater in Europe as the ECB absorbs high-quality paper.
- German Bunds are favored by many investors for their quality and liquidity. Yet, the stock available to the private sector is only 10% of Eurozone GDP. If the ECB buys sovereigns according to the capital key, the central bank will soak up €65 billion of Bunds per year at a time when net issuance will be close to zero.
- The ECB has cut the deposit rate into negative territory, a policy that neither the U.S. nor Japan have ever deployed. Negative nominal rates at the short-end could turbocharge the impact of QE because many investors are understandably averse to negative nominal yields. Investors unwilling to accept negative yields will be forced to move further and further out the curve in search of positive yields.
U.S. and global bond yields bounced higher around the time that QE2 and QE3 were announced. The Fed’s policy action sparked a ‘risk-on’ phase that caused capital to rotate out of fixed income assets and into riskier asset classes for a while. Our base case is that the same will occur initially in the Bund curve if the ECB ratifies or exceeds market QE expectations this week.
Nonetheless, the supply/demand backdrop in the European bond market is sufficiently tight that there is a non-trivial chance that European bond markets will rally in the weeks following the announcement. If so, contagion would drag Treasury and gilt yields lower as well.