ECB Learns a Lesson on How to Run a Bond Market

(Bloomberg Opinion) -- The rate of change in financial markets has accelerated since Russia invaded Ukraine. With the market plumbing thus far proving sufficiently robust to accommodate wilder price swings accompanying risk transfers, even the relatively humdrum world of government debt is having to adapt. Specifically, the euro zone's guardians of monetary stability, led by the European Central Bank, are having to intervene to reduce friction in their capital markets. It should be a wake-up call that liquidity can't be taken for granted. 

Tuesday saw a huge rush into the perceived safety of top-quality government bonds. The corresponding yield collapse was most pronounced in Europe, with the rate on Germany's 10-year security even turning negative once again, triggered by comments from Finnish central bank chief Olli Rehn that the the ECB should wait before exiting its stimulus programs.

But a one-day decline of more than 20 basis points in the region's benchmark debt yield is an extraordinary occurrence, and such a violent move warrants closer scrutiny as to how easy it really is to trade government securities. A smoothly functioning bond market is a prerequisite for financial stability. Instead, there was a massive short squeeze across Europe as primary dealers desperately tried to cover sales to global reserve managers who have been actively adding to high-quality collateral.

The lack of free float in core European government bonds has long been an issue, but it is by design rather than chance. The bloc's central banks between them own 3 trillion euros ($3.3 trillion) of the market as a result of the quantitative easing program that has kept borrowing costs at ultra-low levels. But that risks starving traders of liquidity. Back in February 2018, the then ECB Executive Board member Benoit Coeure estimated that the available-to-trade proportion of bunds was just above 10%. It is almost certainly even lower now as central banks around the world have cornered the best quality collateral for their reserves. The Dutch, French, Austrian, Finnish, Irish and Belgian market free floats are also relatively very low by global standards. And that can cause problems at times of stress such as the markets are currently experiencing.

On Thursday, Germany took the rare step of issuing new bonds two weeks before a scheduled auction, selling 2.5 billion euros of the two-year benchmark 0% issue and increasing its size to 8.5 billion euros. It acted early in an effort to reduce stress in the repurchase market, where dealers needing to borrow specific bonds trade with long-term holders in return for a fee. Surging demand for the two-year German bonds had increased the risk of “fails,” whereby traders can't get their hands on particular bonds to meet their commitments. In statements, the Finance Agency referred to an “exceptional situation” caused by the securities being “held by institutions that have been excluded from trading.” The risk is that such shortages become more commonplace.

Both the Federal Reserve and the Bank of England have long been more accommodative to their primary dealer communities than their peers in the euro zone, offering a range of facilities to access in-demand bonds that have potential delivery problems to keep the whole settlement process functioning smoothly. The Fed's standing repo facility is the latest addition to help eligible counterparties raise cash, but it also works in reverse when dealers need to borrow particular securities. The U.K. central bank, along with the Treasury's Debt Management Office, has a raft of liquidity insurance facilities.

Fed Chair Jerome Powell reiterated his new watchword of being "nimble" this week at congressional hearings. It is a mantra that the national central banks in Europe should adopt with regard not just to their purchases of government bonds but also their sales. Keeping the financial system working requires flexibility. It is good to see the German authorities adopting that. More, please.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

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