Resistance is futile, a Bank of America Merrill Lynch report noted. Based on the European Central Bank’s corporate sector purchase program – buying corporate bonds – free markets are no longer free. The “creeping influence” of the CSPP program can now be felt in almost 70% of eligible corporate issues. Liquidity has deteriorated and bunds with their negative interest rates, well they are just flat out “embarrassing” other investments.
“Magic people” can distort free markets for only so long
The power of ECB “magic people,” who at times operate above reproach, is evident when their logic is questioned. They, after all, have the PhD’s and they know better.
Core economic principles and supply and demand market structure, those concepts are for the little people. Voices of concern that their quantitative dopamine has created unsustainable market prices and muted true price discovery, that concept can not to be discussed in ECB rarefied air.
These were not the thoughts of BAML, of course. But with a few more degrees of unfiltered analysis it could have been. BAML Credit Strategist Barnaby Martin, Credit Derivatives Strategist Ioannis Angelakis and Credit Strategist Souheir Asba did their fair share of subtly pointing to market events that highlight central banks distorting corporate credit markets. But perhaps most important they see a trade opportunity in the land of interest rate manipulation.
Honesty doesn’t pay, really
Under the heading of “Honesty doesn’t pay,” BAML thinks Monday could “prove to be a watershed moment for the credit market, and potentially for risk assets more generally.”
With corporate bond markets being influenced by a “creeping” artificial stimulant, the report thinks transparency applied to the central bank’s corporate purchases will create an unintended consequence.
“While CSPP disclosure is meant to alleviate concerns over market distortion, we fear that it could, perversely, make eligible bonds more illiquid,” BAML said, noting that perverse concepts that were once considered unthinkable – central banks at first buying government bonds but now corporates – is now actually happening. We live in a world where the perverse is now the new normal. The question is how long will it last?
“Disclosure could well be the catalyst that forces investors to flee eligible names and rotate more forcefully into non-eligible sectors post summer,” the report predicted.
In other words, “real” investors should flee names where central banks have inflated the price – the ultimate mean reversion trade.
When looking at a “pecking order” for bond rotation, BAML likes corporate hybrids at the top of the list. “Spreads have lagged, yields are very attractive compared to senior non-financials, and CSPP makes hybrids less essential for companies,” Martin and his team opined.
Also on the list, in pecking order listing, BAML likes US investment grade bonds on the assumption “big foreign inflows and leverage to decline towards year-end. Also on the list are European bank bonds and banks – which, depending on the result of Friday’s EU stress test, may be able to be purchased on a drawdown.
What did the ECB’s modeling of its impact of corporate bond buying on the market look like? Did they anticipate that “real” liquidity in the market might dry up when central banks were documented to have been moving into certain corporate issues? This is the question that will likely go either unasked or unanswered, but the issue that matters most.
BAML, for its part, notes that CSPP bond buying began “in earnest” June 8. Perhaps most significant, from that point “credit market liquidity has actually deteriorated.”
Near month’s end there was of course a shock to the system that impacted results on a temporary basis.
“Brexit has of course transpired in the meantime, but nonetheless bid-offers for investment-grade bonds have been moving higher,” the BAML analysts observed. “And the disclosure of ISINs looks to have been, paradoxically, unhelpful for liquidity as well.”
Someone needs to ask for ECB modeling on unintended consequences of free market interference
It would likely be “embarrassing” for the ECB to reveal that they didn’t model the unintended consequences of their own central bank market intervention. But that liquidity sapping event, if it occurs, is not as “embarrassing” as negative interest rates.
What is embarrassing is how German bunds – now at negative interest rates – have beaten other investments over a similar period. Those of you who thought interest rates had a floor at zero, well, how foolish that notion was. Is this the beginning or the end? BAML has an opinion:
More generally, we believe that the “portfolio effect” (or simply the reach for yield) has only take baby steps thus far in Europe. And neither has it had to. Bunds have “embarrassed” many risk assets over the last few years in terms of performance. In fact, cumulative total returns for bunds since 2014 have trumped Euro high-grade, BBs, corporate hybrids and even AT1s. The ECB’s foray into negative rates – and the expectation that monetary loosening was therefore endless – has kept government debt an attractive risk-reward proposition. Thus, the brakes have essentially been put on the portfolio effect in Europe.
In an interesting sign, the BoJ and the ECB could begin to move away from negative interest rates. They point to Gilles Moec, BAML’s chief European Economist who cut his teeth at Deutsche Bank, has an opinion on the popularity of negative rates.
Gilles Moec thinks that more interest rate cuts or buying below the deposit rate floor are now unappealing to the ECB given the toxicity of negative rates for the banks. If the message that begins to permeate through is one of a lower bound for yields, then we think that this could kick-start a more forceful portfolio effect in Europe. This should benefit high-yield (where YTD outflows have been close to $10bn.) and even European equities (where stocks for CSPP purchased names have clearly lagged their bond equivalents).
There is a relative value trade in there waiting to happen. One might say it is a play on central bank free market intervention.