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The ECB's purchases create the volatility it deplores

The European Central Bank has expressed concern about extreme rates volatility. But until it stops buying and allows the private sector to become re-established, its true mission as liquidity provider of last resort will remain in conflict with its determination to expand its balance sheet.

On Monday, ECB board member Benoît Coeuré said he was worried about the rapid reversal in Bund yields, describing it as yet another episode of "extreme volatility".

Volatility has rippled across all credit markets, hitting absolute returns, and nowhere more so than in those markets directly affected by the central bank’s purchasing programmes, such as covered bonds.   

As the ECB has stepped up its covered bond buying, so have other central banks across the world. The primary market allocation of covered bond issuance to official institutions has risen from 9% before the latest covered bond purchase programme began to 31% since it started, according to analysis by Crédit Agricole research.

But over 80% of the €80bn or more that has been purchased has been in the secondary market, the actual increase in the central bank allocation is likely to be far higher.

More importantly, this increased share has squeezed out other private sector buyers such as asset managers and insurers. This is especially the case for peripheral borrowers which have relied more heavily on demand from these types of investors.

The problem they and the ECB face is that many of these buyers will have cut their credit lines to covered bonds and reallocated internal resources to different products. That means they will not readily return when the ECB leaves the market in September 2016, leaving the market thinner, and more exposed to extreme moves.  

So while the ECB’s first and second covered bond purchase programmes were aimed at improving liquidity and access to the market, the third programme will work in the opposite direction and could leave the central bank back where it started.

Thinner, more volatile markets will probably encourage covered bond issuers to rely more heavily on short term repo funding, courtesy of the ECB. While this may well help to expand the central bank’s balance sheet, it is difficult to see how causing funding stress will raise price inflation expectations and improve lending into the real economy.

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