April 20, 2024

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ECB Undid a Fail But Left Collateral Damage

(Bloomberg Opinion) — The wild swings in bond values in recent weeks have undermined investor trust in the fixed-income markets just when governments need them most as they scramble to protect their pandemic-afflicted economies. While the European Central Bank’s new 750 billion euro ($820 billion) bond-buying program gets the institution where it needs to be in supporting the euro zone, the collateral damage of prior false starts may endure.

ECB President Christine Lagarde last week  told the world “we are not here to close spreads,” prompting Italian bond yields to shoot higher. This week, she said there are “no limits” to what her institution will do to safeguard the common currency project. Italian yields have duly plummeted.

As the chart above shows, both Italian and Greek 10-year yields have made daily outsize moves far beyond what is typically experienced in a single trading session. That will have generated losses for portfolio managers who found themselves on the wrong end of a market move — potentially big enough to close a fund. Others who fared better will still have had their confidence shaken. Investors facing price swings of 10% or more in a single week, which they just experienced in Greek debt, are likely to curtail their trading activity.

Liquidity in the euro zone’s benchmark fixed-income market was already tight. In a February 2018 presentation, ECB executive board member Benoit Coeure outlined that the free float in German bunds — securities available for market participants to buy and sell that weren’t locked in official accounts at the central bank and elsewhere — amounted to roughly 15% of the total outstanding. That proportion is likely to have fallen since, and will shrink further as the central bank resumes bond buying.

The ECB will be greatly encouraged with the rapid reduction in government borrowing costs in the euro zone following its latest moves; unleashing more than 1 trillion euros of stimulus in 2020 has to have some effect. But there has been an unseen cost. Risk managers will have to reduce exposure to what will in future be classified as volatile assets. Extreme price moves deter trading and will further reduce already impaired liquidity in the cash bond markets.

These problems are doubly bad for market participants that hedge their euro sovereign bond trading by taking counterbalancing long and short positions, whether for risk management purposes or because they are market makers. Over the last week hedges may have amplified losses rather than mitigated them.

Reduced liquidity in the sovereign bond market can only be bad news for finance ministries that will have to increase bond sales to fund the rehabilitation of damaged economies. This is clearly an exceptional point in history and the rapidly increasing financial impact of the coronavirus explains much of the volatility in asset prices. But it is regrettable that central bank missteps exacerbated market instability. The ECB acted swiftly and decisively to reverse its earlier error; the memory of its clumsiness will take longer to fade.

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

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”

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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