How things change over a few months; just only a few months ago, the word on the street was that the large part of eurozone was debt-laden and had too much outstanding debt on the secondary markets. Now, with the ECB having already stated that it intends to buy €60bn worth of bonds each month for the next 19 months, the question out there is: Will the ECB find enough supply from existing bondholders to shore up this pre-determined demand? Will the ECB come across any obstacles in implementing its QE program? Why are markets weary about possible execution risk?

One of the key issues in 2015 is that net issuance is expected to be negative by €200bn, which effectively means that more bonds are to mature in 2015 than bonds are expected to be issued, which also means that the supply of bonds in 2015 will shrink by €200bn. If we had to go back a few years at times when QE was being implemented in the US and UK, this phenomenon was clearly not an issue. Also, when the US Federal Reserve embarked on its QE asset purchase program and buying US Treasuries, investors had the so-called luxury of shifting out of their US Treasuries and re-invest process within the same asset class (fixed income), which at the time was sufficient liquidity in the markets (corporate and mortgage markets) to make up for the increased demand. Back then, US investors could mix and match their asset allocations to suit their investment yields knowing that they were still in the running to earn a good return.

And this is where the execution risk issue of the ECB might come in to play. Why should an investor sell his/her government bond exposure (Malta Government Stocks in Malta) today, if 1) the price of government bonds is expected to continue to rise (ECB’s Draghi stated last week that the ECB is ready to purchase bonds up to negative yields of -20bps) and 2) if returns of other assets within the same asset class and of similar rating are trading at ultra-low yields and do not warrant the increase in risk exposure? Furthermore, the European corporate bond market is not liquid enough, the ABS market is too small and the ECB also has it in its mandate to purchase covered bonds. And therefore QE is expected to continue drying up liquidity in the markets. The next best alternative would be rotating out of fixed income into equities, but some could argue whether current valuations are outstretched (lest we forget that European equities have returned a whopping 14% so far this year).

It is important to keep focusing on the ECB’s intentions behind QE, and that is primarily creating inflation in line with its mandate. Following last week’s comments, bond yields across all segments of the yield curve are expected to lower further (bond prices will rally) in the short-term, so one would expect a marked flattening of the yield curve. However, and we cannot but stress the importance of this next statement, we must also keep in mind that 1) if and when inflation starts to pick up, 2) lower oil prices start being reflected in higher purchasing power of European consumers and, 3) the weaker euro translates into an uptick in imports significant enough to result in a meaningful effect on inflation (not a scenario we expect to unfold anytime soon, I could take well over a year to materialise), it is the longer-dated bonds which will remain particularly vulnerable to a correction, albeit we expect any correction to be gradual.