There is mystery afoot in the European bond market.
Or you could say, Professor Merkel has been found in the Bundesbank with the lead German bund.
This tale revolves around what analysts are already describing as the worst auction of German bunds in recent times.
As Bloomberg noted, the German government sold €3.6bn ($4.9bn) in new 2 per cent 10-year bonds at an average yield of 1.98 per cent on Wednesday.
The total auction was meant to be for €6bn. As such, this can be described as technically uncovered.
Or as Marc Ostwald, of Monument Securities puts it:
I cannot recall a worse auction, only EUR 3.889 Bln of bids in total for a EUR 6.0 Bln auction, and this is the new 10yr benchmark, and that is a cover of 0.65x. IF Germany can only manage this sort of participation, what hope for the rest. YIELDS are at completely the wrong level.
The uncovered technicality comes from the fact that the Bundesbank (via the Finanzagentur) habitually retains some of the paper from every major bond auction for the purpose of its ‘market operations’. But to understand why this is important one first has to explore how central banks actually set rates.
In normal times, when unsecured lending is the norm, all a central bank really has to do in order to “set” a market rate is announce its target. Generally speaking, the market would then comply because it is the central bank which controls the ultimate cost of emergency funding.
If the effective rate, due to supply and demand reasons, failed to follow the target rate, the central bank would use its markets operations team to ensure the rate it wanted was enforced in the market. The easiest way to do this was always through government bond markets, specifically by taking aim at something known as the “repo rate”.
If the central bank wanted to raise rates it would simply release additional bond stock into the market until there was a surplus of paper with respect to demand. In that event dealers would be inclined to adjust their private market quotes to reflect the additional supply and quote higher rates to each other. If the central bank wanted to cut rates, meanwhile, it would go into the market to absorb bonds through repurchase agreements instead.
The mechanics are very similar to central bank intervention in foreign exchange.
As with FX intervention, the success of the operation is completely dependent on the actual size of the float or reserves that the central bank holds. In theory, rate cuts are therefore much easier to enforce, since there is no limit on how much the central bank can absorb from the market. Raising rates, meanwhile, is much harder because it is dependent on having existing stock to release into the market.
The same is true of foreign exchange intervention. Debasing a national currency is easy, you can simply print more currency. Supporting your currency is completely dependent on your stock of foreign reserves. Once those run out (as the breaking of the Bank of England proved) you’re rendered powerless.
In the bond market the same concept sort of applies. Except that while there is in theory no limit on repurchases, there is a limit to raising rates if your reserve stock runs out. This is why some central banks operate so called phantom bond facilities (through government agencies) which temporarily issue phantom bonds into the market to ensure rates could never in theory be restricted due to a shortage of central bank-held bonds.
The Bundesbank, however, does not have a phantom facility. As we have noted, the debt agency instead habitually retains float from auctions to build up buffers it can then release into the market when needed for rate setting purposes. Or in the age of the ECB to ensure the market continues to function smoothly.
Wednesday’s bond auction, however, has seen the amount retained by the Bundesbank (via the Finanzagentur) reach an unusually massive €2.356bn. But it’s unlikely to have been intentional.
So what is the mystery?
The mystery is this chart:
There is what can only be described as an anomaly in the market. As FT Alphaville has written, repo experts believe German bunds are currently trading at “special” rates across the board. There is no such thing as “general collateral” because there is not enough float available for borrowing across the board, not just in specific securities. Whoever owns German bonds is currently reluctant to lend them out — a fact which is depressing the so-called repo rate.
Except there is one problem. That specialness explanation — i.e. bunds are special because of the virtue of the asset — doesn’t compute with the auction participation.
What’s more, if bunds were really that special, this would usually see the Bundesbank intervening in the market to ensure that the specialness eased. Except, the Bundesbank (via the Finanzagentur) has not been seen repo-ing securities in the market since 2009.
If it had the term “Forderungen aus der Wertpapierleihe (nominal verzinslich)” would have appeared in its latest report here.
And just to be sure, we checked with the head of institutional investor relations at the Finance Agency of Federal Republic of Germany earlier this month, who confirmed no reverse repurchases or “stock lending” had taken place since September.
That, alongside the fact that the Bundesbank is retaining an ever greater share of bonds from auction, suggests only one thing to the logical mind. It is the Bundesbank which may be cornering the bund market on purpose. And it’s doing so to ensure that the one last repo rate in Europe that can be controlled remains suppressed.
The rate is important because almost all interbank funding is now done on a secured basis against the best quality collateral. This implies two important points: 1) that the ECB itself has lost control and depends almost entirely on the Bundesbank to enforce its low rate policy target and 2) that the Bundesbank is having to retain more bunds from the market than ever before just to ensure the last functioning repo rate in Europe doesn’t spiral out of control.
That, we would say, is a big deal.
Whatever the case, Wednesday’s auction suggests the Bundesbank’s stealth operation may have finally been outed. The question is, will the Bundesbank now be broken too?
*The Economist notes:
The Finanzagentur issued only 3.9bln cash. They gave 3.9bln bunds to the market and kept 2.1bln bonds on their books. In the future they can sell this retention amount into the secondary market, raising cash. You may have read that the Bundesbank bought the unfilled part of the auction; this is not correct. The Bundesbank is not financing Germany; it just operates as an agency for Finanzagentur. It is worth repeating that Finanzagentur always retains part of the bonds, so this part of the process is normal. Today the retention was larger than usual. This is probably due to low liquidity across market, lower incentive to place certain minimum size bids by dealers, and richness of bunds in general.
To be clear, every central bank and debt market operates differently. In Germany’s case the Finanzagentur is charged with holding back stock and provides a stock lending service to ease market dysfunction. The Bundesbank operates in the market out of its own accord and its market operations are not publicly known.
This is not debt monetisation.
The curious anomaly is, as we have noted, if bunds are special, why is there poor auction demand, and why is noone borrowing stock? That is the mystery.
Related links:
Eurozone GC is splitsville - FT Alphaville
Bunds get Junckered, and other repo dysfunctions - FT Alphaville
Italian settlement fail penalty, bond sell-off — causation or correlation? - FT Alphaville
An existential crisis in Eurozone rates [updated] – FT Alphaville