European Central Bank Smothers Government Bond Market -- Update

By Anna Hirtenstein

The European Central Bank is vacuuming up sovereign bonds faster than governments can pump them out, keeping a tight lid on borrowing costs as the region spends on coronavirus relief measures.

The strong appetite from the ECB has kept yields on government debt in the region pinned extremely low. On Friday, yields on benchmark 10-year German bunds edged down to minus 0.484% from minus 0.427% on Thursday. But the real beneficiaries have been Europe's riskier borrowers. Italy's 10-year bond yield has stayed close to 1% since the end of July and dropped as low as 0.976% Friday.

Analysts figure those low rates can persist. Even as European countries issue more debt for relief spending, the ECB is more than making up for it. UBS expects the net supply of European government bonds to be minus EUR73 billion in 2020, equivalent to $86 billion, compared with EUR182 billion last year. This means that the central bank is projected to buy more bonds this year than governments sell, after factoring out bonds that are repaid.

"This allows governments to easily finance the huge expansions to fiscal spending," said Rohan Khanna, a rates strategist at UBS. "The ECB's presence is important for smooth market functioning."

The central bank on Thursday reiterated its commitment to bond purchases. It announced a EUR750 billion bond-buying program in March as part of its quantitative easing strategy to bolster the eurozone's economy through the pandemic, raising it to EUR1.35 trillion in June. It is buying a mix of sovereign and corporate debt -- and has the flexibility to direct capital to the areas most in need rather than spreading it evenly across the eurozone's economy. This is in addition to the continuing asset purchase program that also bought billions of euros of bonds every month from 2014 to 2018 and since November 2019.

This year through to Sept. 4, the ECB has spent EUR676 billion on government bonds, according to the latest figures it has published. That is compared with EUR367 billion of new issuance from eurozone countries in the same time frame, data from Dealogic showed.

The ECB buys bonds in the secondary market and not directly from debt management offices in order to skirt the controversial notion of monetary financing. Since there aren't enough fresh bonds for the ECB to buy, it also relies on existing bonds that were issued in previous years.

Yet its outsize role in the market has smoothed the way for governments to borrow. Earlier this week, Italy sold 20-year bonds to raise EUR10 billion, at a rate of 1.8%. As recently as April, yields on 20-year Italian bonds were above 2.8%, according to FactSet. Greece issued 10-year debt on Sept. 2 to raise EUR2.5 billion at a yield of 1.2%, less than a third of the benchmark bond yield's highest level during the turmoil in March.

"The impact is tremendous," said Ben de Forton, a debt capital markets banker at BNP Paribas SA with a focus on sovereign borrowing. The European Commission has forecast that the Italian economy will contract 11.2% this year, the worst-hit in the region.

"The market expects a large buyer to come in every day and that supports pricing even when there may be weakness due to some esoteric headline or economic data," said Richard Gustard, head of European bond trading at JPMorgan Chase & Co. "The market would sell off if the system didn't buy."

For now, the ECB's huge appetite is suppressing traditional worries about the fragility of Europe's government finances, especially in places like Italy, Greece and Spain.

"I'm comfortable holding Italian debt right now, but these issues should all be expected to come back in the future," said Andrew Mulliner, a bond portfolio manager at Janus Henderson Investors.

It isn't the first time the ECB has bought more bonds than governments issue. The same dynamic played out from 2015 to 2017, when the central bank was aggressively buying bonds to pull the region out of its sovereign debt crisis recession. It tapered that program in 2018 as the economy began to improve. With less demand from the ECB, yields in Southern Europe began rising again. The extra yield on benchmark 10-year Italian debt over German shot above 3 percentage points for a spell in 2018, doubling compared with the level at the end of 2017.

Some think it will be a long time before the ECB pulls back.

"The ECB is a very, very long way away from hitting its inflation target of 2%," said Seamus Mac Gorain, head of global rates for J.P. Morgan Asset Management Inc. "The easiest tool they have for this is the bond purchase program." His fund is overweight southern European debt, meaning it holds more than the benchmark it tracks.

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