Government bond markets in a changing environment
European Central Bank
Directorate General Communications
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Keynote address by Benoît Cœuré, Member of the Executive Board of the ECB, at the Government Borrowers Forum, Paris, 3 May 2016
In a keynote address at the Government Borrowers Forum, in Paris, ECB Board member Benoît Coeuré analyses the impact of recent policy interventions on market functioning. His remarks focus on unconventional monetary policy measures, regulatory developments and private-public partnership in financial market reforms. «Policy interventions are having an impact on market functioning today» he says, but in the case of the ECB’s monetary policy, «ongoing monitoring so far does not suggest impairments to the price discovery process» and «our monetary policy has not suppressed market discipline». The new market environment is more constrained, but also more resilient. «At the same time, more safety is not a substitute but a complement to well capitalised banks and sound public finances» he concludes.
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Let me begin by saying thank you to the World Bank and the Agence France Trésor for inviting me to speak today.
The speed of change during the financial crisis, and of the regulatory responses to it, has particular resonance for borrowers who think in long time scales, such as governments. Six years have now passed since the famous Pittsburgh G20 communiqué, where many initiatives for the ongoing regulatory agenda to prevent similar crisis in the future were launched. Some of those initiatives have already had a profound impact on global interest rate markets, such as those related to derivatives clearing and market transparency. Yet six years is also significantly shorter than the average new issuance maturity for the government borrower members present here today. This implies that many bonds issued in 2010 will be rolled over in very different markets – from level, structural and regulatory perspective – from those that we knew at the time. And that is not to mention the ultra-long bonds recently issued by several governments, including France’s latest 50 year issuance.
In some cases, for instance for trade reporting and transparency, the crisis simply provided the necessary catalyst for overdue improvements in market practices. In others, related for instance to risk-taking by banks or the rigging of benchmark rates, the bad practices of the past had to be curbed by regulatory fiat. A third group of changes, such as the rise of electronic trading, were happening already before the crisis. While it is straightforward to see the steady-state benefits of all these developments, the potential side effects and transition problems are more difficult to assess. As a result, a holistic assessment of their impacts on systemic stability and economic efficiency is needed. But that is beyond the scope of my remarks today.
What I would like to focus on is one issue in particular, namely the impact of recent policy interventions on market functioning. Specifically, I would like to discuss three areas: the impact of unconventional monetary policy measures; the impact of regulatory developments; and the role of private–public partnerships in financial market reform.
1. The impact of unconventional monetary policies
Starting with monetary policy, the key issue is as follows. Efficient price formation requires that large transactions can be rapidly executed at low cost with limited price impact – i.e. that markets are liquid. But are unconventional measures, such as negative interest rates and asset purchases, positively or negatively affecting market liquidity conditions and thereby that price formation mechanism? It is of course difficult to disentangle the individual effects of each of the policy measures we have taken in the recent years, as they have all been introduced as part of wider policy packages. Still, there are some points that can be made about the tools in isolation.
First, negative interest rates on our deposit facility. Beyond some initial hesitation, the transition to negative rates has happened smoothly in both capital and money markets. The technical challenges related to the implementation of negative rates, notably in terms of market infrastructures, have been well anticipated and addressed by market participants, and we now have proof that market functioning below zero does not imply different logics and mechanisms. Or as I said elsewhere, there is life below zero.[1] In particular, possible adverse effects of negative rates on general trading activities seem to have been limited. While volumes in the euro money markets have been declining[2], they have been also impacted by the significant increase in excess liquidity as well as regulatory developments.
A case in point is the volumes traded in the Eonia market, which did fall substantially after the deposit facility rate was cut below zero in 2014, but are up 60% since the beginning of this year. In addition, negative rates have been accompanied by receding fragmentation in the unsecured overnight money market, at least for the higher-rated counterparties. For example, the spread between rates paid by banks with an investment grade credit rating in formerly stressed and non-stressed jurisdictions is close to its pre-Lehman level and significantly improved since mid-2012. The secured money market and security lending market have also been fairly resilient, and repo markets in formerly stressed jurisdictions have seen noticeable increases in trading activity, thanks to an overall improving environment. These developments are all the more important for us at the ECB since we take great care to ensure that our exceptional policy measures do not have an irreversible impact on market structures.
More generally, we have not yet seen negative rates have a major impact on market makers themselves – in particular via the topical channel of banks and their profitability. I can only repeat here what the ECB has already said on several occasions, namely that banks’ profitability has actually improved when you look at the overall impact of our monetary policy, thanks to a combination of lower funding costs, increased lending volumes and lower loan-loss provisions, which dominates by far the direct cost of negative rates. To be sure, this would not necessarily remain true if the deposit facility rate were to be set at significantly lower levels. But this is why I have said elsewhere that we would not take it to absurdly low levels.[3] If anything, the smooth changeover to negative rates has only underlined the adaptability of market participants to this new environment, especially the money market funds industry.
Turning to the longer end of the yield curve, can the same upbeat assessment by made about our asset purchase programme? As of 2 May, the ECB had purchased EUR 733 billion of securities under its Public Sector Purchase Programme (PSPP). Theoretically, such large-scale asset purchases by the central bank could have either a positive or a negative effect on market liquidity. On the one hand, the willingness of the central bank to purchase assets reduces market risk for potential buyers – that is, the risk that they are unable to sell the assets later on when needed to obtain liquidity. Such investors might therefore be ready to buy those assets at a somewhat higher price, which compresses the standard measure of market liquidity, the bid-ask spread. This situation is more likely in cases where investors fear that markets might become disrupted and demand dries up.
On the other hand, with central bank purchases the risk that potential sellers might be unable to sell at a later point in time is also reduced. Those investors may therefore be ready to sell now only at a somewhat higher price, which makes the bid-ask spread wider. Moreover, if the central bank holdings of a particular security are sizeable relative to the total amount issued, that security becomes scarcer. This can translate into longer inventory holding problems and higher trading costs and this case investors will be more reluctant to hold those securities.
In other words, the impact of the PSPP on market liquidity remains an empirical question. And looking at the available data, we do not see evidence of significant disruptions in market functioning.
First, price discovery appears to be smooth and issuers are able to place new securities to the market in large volumes. Trading volumes have not fallen systematically as a result of PSPP. Based on TradeWeb data, trading volumes in core markets such as Germany are roughly 5% lower than two years ago. However, trading volumes in Italian, Spanish and Portuguese bonds on that platform are around 20% higher. That said one should not draw hasty conclusions from what remains a fragile set of indicators. Too little is known of the liquidity offered by dealers to end-investors. And therefore, the ECB will monitor market liquidity carefully as our asset purchase programme is further rolled out.
Second, it is important to learn from Arthur Conan Doyle and note ‘the dogs that didn’t bark’. We have witnessed several shocks since we began our purchase programme that, in other conditions, might have led to substantial market volatility. For example, the major realignments of global FX reserve portfolios in the summer of last year passed without a significant increase in euro area yields or yield volatility. In this sense, the presence of PSPP has aided market functioning by providing a constant source of demand in the market and by flexibly directing this demand towards particularly oversold securities. At the same time, the spike in sovereign yields in Portugal earlier this year shows that our monetary policy has not suppressed market discipline.
Finally, as general remark, one should always keep in mind that our combined measures are designed to prevent growth and inflation from being too low for too long. If we allowed such a situation to materialise, the impact on banks and investors would be much more severe than the impact our measures are said to have.
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Directorate General Communications
Sonnemannstrasse 20, 60314 Frankfurt am Main, Germany
Tel.: +49 69 1344 7455, E-mail: media@ecb.europa.eu
Website: www.ecb.europa.eu
