The ECB's Groundhog Day
Until the European Central Bank (ECB) changes the rules associated with sovereign bond purchases, the duration of its holdings will steadily increase. This introduces a self-reinforcing dynamic. When yields drop, the ECB is forced to buy more, putting further downward pressure on yields.
In a previous post ("Running out of things to buy"), I outlined how the ECB was running out of German bonds to purchase under the Public Sector Purchase Programme (PSPP). A relaxation of their self-imposed restrictions is necessary for the programme to continue into 2017.
All of the options for relaxing restrictions look fairly unpalatable. So, in time-honoured ECB fashion, this implies delaying the decision on which option to pursue. In the meantime, the ECB has got itself in a trap of its own making. By refusing to change the rules on asset purchases, it is locked into a pattern of steadily increasing the duration of asset purchases.
This effect is especially pronounced in the German market where the restrictions are most binding. At the beginning of the year, the average maturity of bund purchases was below seven years. Today it is nearly nine years. This number will keep going up until the restrictions are loosened.
Most concerning is the self-reinforcing dynamic this introduces.
When German yields drop, the ECB is forced to buy more (in duration-adjusted terms), which puts renewed downward pressure on yields. This cycle won’t be broken until we get a clearer message on how the ECB will square the circle of only buying bonds with yields above -40bp, whilst simultaneously committing to purchases of €80bn per month (with 25% of this committed to the German market).
Welcome to Groundhog Day.