As explained in these pages exhaustively, last month’s “Holy Schatz” moment that saw the front end of the German curve richen dramatically was probably due more to the ECB buying below the depo rate than it was to a flight-to-safety bid associated with rising Dutch and French election risk.
The market’s initial interpretation was that the plunge in German 2Y yields was attributable to a combination of i) ECB buying below the depo rate, and ii) a safe haven bid tied to political jitters.
The rally created all manner of aberrations and distortions, including but (probably) not limited to, i) iTraxx Main trading inside 2Y swap spreads, ii) an explosion in negative spread corporates, which was ironically catalyzed by CSPP.
Again, there was quite a bit of debate about the extent to which the plunge in Schatz yields could be explained by investors fleeing to safety ahead of Europe’s upcoming trials by electoral fire. That sounds esoteric, but it’s pretty important. That is, if it was more front-end QE than it was flight to safety, then we can’t really read much into it in terms of using it as a barometer for political uncertainty.
Once we got the monthly ECB QE data, the debate was for all intents and purposes settled. Recall the following from BofAML:
Today’s monthly ECB QE data implies a substantial drop in the Weighted Average Maturity (WAM) of monthly German bond purchases, from an estimated 9.4y in January to a record low 4.3y in February (Chart 8). This is derived from the decline in the remaining WAM of the German QE portfolio (to 7.88y, from 8.15y at the end of January). The 4.3y figure is right in line with the level we had envisaged when assuming that Bundesbank govie purchases would be split across the curve (1-31y) in proportion of remaining eligible amounts (see scenarios analysis in EU rates). More importantly, consensus was probably looking for a much higher WAM even as purchases below the Depo started.
As the German front-end was rallying substantially in Feb, we argued that the move could be due to the market being caught off-guard by a possible large QE bid in the front-end; the higher than expected weighted average maturity (WAM) of German QE purchases in January may have led to expectations that the ECB would resist buying much in the short-end.
We think today’s release comforts our finding that the larger-than-expected German QE buying in the sub 5y sector and non-EUR CB interventions (eg SNB, CNB, Danish CB) were likely responsible for over 50% of the richening in Schatz & Bobl vs OIS in Feb.
Ok, so just to reiterate, the reason that’s important is because if all we were seeing in the German front end was QE buying, then by extension, we weren’t seeing risk aversion. In other words: the richening we saw in Schatz can’t be interpreted as the market pricing in political risk.
Of course Mario Draghi, in an effort to avoid admitting that ECB buying was causing distortions, chose to go the “flight to safety” route when explaining the plunge in German 2Y yields. Goldman has decided to test that. Here’s what they came up with on Wednesday morning:
In response to a question at his March press conference about the drivers of recent distortions in the short end of the German sovereign yield curve, ECB President Mario Draghi responded that “there has been what we call a flight-to-quality phenomenon” into German bonds.
‘Flight to safety’ (FTS) is frequently invoked as an explanation for falling yields. But yield movements alone are not enough to disentangle a ‘flight to safety’ episode from other motivations for holding government bonds. We use daily data on the spread between the return on 10-year bond indices and that on equity in 17 European countries to identify potential FTS episodes. We use German Bunds as the safe-haven bond for all Euro area countries, and domestic equity indices for equity returns. The overall intuition of the exercise is that safe bond prices should rise, and risky equity returns should fall, when there is a general, broad-based rise in investors’ preference for safe and liquid assets. The information embedded in this spread can therefore be used, with the appropriate model, to provide us with a broad ‘macro’-level identification of ‘flight to safety’ episodes.
We find that on aggregate, the Euro area should be classified as a two-regime system, which alternates between periods of broadly higher preference for safe assets (‘risk-off’) and broadly higher tolerance of risk (‘risk-on’). Exhibit 2 shows the probability that the Euro area as a whole is in a ‘risk-off’ phase. By contrast, France is classified into three regimes, with periods of acute preference for safe assets identifiable (‘flights to safety’). Exhibit 3 plots the probability that France is in a ‘flight to safety’ phase. Together, Exhibits 2 and 3 suggest that, on our definition, there is little support for the claim that France is in the midst of a flight to safety episode at present, or indeed that Europe is in a ‘risk-off’ phase.
Did you connect the dots? What all of the above means is this: election risk definitely not priced in.
More broadly, what Goldman discovered is that based on their model, everyone in the Western world is firmly in risk-on mode and there hasn’t been a “flight-to-safety” since Brexit…
That’s a nice run, but as we saw on Tuesday, all good things must come to an (unceremonious) end.