Good morning!

The first week of the European Central Bank’s (ECB) bond buying programme, dubbed expanded asset purchase programme but more often referred to as Quantitative Easing (QE) appears set to close its debuting week on a strong note. In fact, the market movements were so strong that they left many wonder whether the ECB will be able to buy as much as it wants to. Throughout this week, the 10 year German yield fell to 0.25% from 0.35% after reaching 0.2% on Wednesday and early Thursday. Peripherals had also a very strong week as the 10 year yields for Italy and Spain approached 1% yesterday (before closing higher).

While I have been bullish about Euroarea sovereigns for some time now I must say that I would have expected the momentum to flatten after a strong start of the year and until the central bank steps up its buying. Of note, whereas ECB targets monthly purchases of EUR60 billion, this is an average monthly target as local central bankers have the flexibility to time their buying according to the local market conditions (i.e. liquidity, new supply, redemptions etc). Notwithstanding this, lower government yields appear to become as self-fulfilling proficiency as the consensus for strong capital gains (i.e. lower yields) leads to stronger demand ahead of significant ECB intervention.

Meanwhile, few appear to have an incentive to sell their holdings of Euroarea government paper. Banks and Insurance companies have a significant exposure to such instruments but for the latter there are few investment alternatives given that their assets are skewed towards bonds so as to match the expected maturity of their liabilities. Banks on the other hand, in a normally functioning economy, would have an incentive to offload some of their holdings to “invest” the proceeds in loans (which have a greater return).

However, these are not normal times. Lending to Euroarea non-financial corporates has been on a downtrend since June 2012, contracting by over 8% since then. Meanwhile, banks’ holdings of Euroarea government debt increased by 20% as they took advantage of earlier ECB stimulus, to borrow cheaply, put the money in sovereign bonds and use them as collateral for more borrowing from the central bank. The authorities allowed such practices on the premise that it will drive yields lower allowing banks to book healthy profits and, hence boost their capital; this in turn was deemed to eventually allow them to grow increasingly confident and start lending.

This has not yet happened in the weaker countries, such as Italy, Spain, Portugal, Greece, Ireland or Slovenia where, in a sort of a chicken and egg dilemma, banks have to content with various factors such as unemployment, politics, high non-performing loans or poor competitiveness. It should thus come as no surprise that lending activity in these countries continues to decline whereas a significant percentage of their assets is in government bonds (for Spain and Italy more than 10%, for Portugal 8% and for Ireland 7%). To put this into perspective, over the last five years ending January 2015, Spanish banks increased their investments in sovereign paper by 90%, while the stock of non-financial corporate loans declined by 40% over the same period; similar divergences are noted for other peripheral countries.

In this context, the behaviour of banks can be instrumental in judging the trend in yields and the likelihood of ECB failing to find enough supply. In my opinion, the gradual decline and convergence in lending rates show that there is hope for a bottoming in deleveraging. Also, the Euro weakening, the fall in oil and the move towards reforms (if sustained) should gradually motivate banks to increase lending activity.

What is more, I believe the ECB will do everything it can think of to progressively nudge banks into kick starting lending as this is the main way in which the extra liquidity created by the central banks can reach the real economy and help growth. In extremis, the regulators can change the way the Euroarea bonds are treated when calculating the capital requirements for banks. At the moment, no capital is required for such assets subject to the local regulatory authority decision (MFSA rules state a 0% risk weighting). In contrast, when extending a loan a bank has to “put aside” capital equivalent to a certain percentage of the amount lent. Relatedly, earlier this week the Draghi endorsed a report published by the European Systemic Risk Board by stating in its foreword that “the current regulatory framework of sovereign exposures held by financial institutions needs to be re-examined at a global level […] I trust that the report will help to foster a discussion which, in my view, is long overdue“.

Finally, it is for sure worth highlighting that the Maltese banks invested as much as EUR2.6 billion in Euroarea government bonds. In contrast to other Euro countries, this figure is only 7% higher than it was five years ago while the outstanding corporate loans of the local banking system declined by a mere 3% over the same period. However, the local banks have EUR2 billion in MGSs (as of end January) equivalent to 40% of the outstanding government paper. Hence, for the Central Bank of Malta it might be indeed a challenge to source EUR36 million on average per month for 19 months and it will likely have to resort to aggressive pricing. More and more so as local yields look attractive when put against those of other Euro countries, Italy and Spain included.

Have a nice day!