Easing starting to really hurt SSA investors
The ECB’s increasingly heavy hints of its intentions have market players thinking that a cut to the deposit rate on December 3rd is almost a foregone conclusion.
But with concerns over profitability mounting money management funds are faced with a predicament: continue to pay to be invested in the SSA market, or move to a highly leveraged corporate market experiencing the highest default rates globally in years.
Yields in the Eurozone are plunging ever lower. Last week, Erste Abwicklungsanstalt became the first non-government guaranteed issuer in the SSA sector to sell a negative yielding bond. Investors took the bet that it was a better yield than they’d find after the ECB’s meeting on Thursday. Fully 40% of sovereign issues in the Eurozone are yielding negatively.
Each new rumour of the ECB’s intentions seems to add to investors’ pessimism. When rumours of a two-tier cut to the cut in the deposit rate broke last week, Rabobank analysts said investors were pricing in a more aggressive overall cut as a result.
What will this mean for money management funds and other investors? Can they continue to absorb negative yielding assets at this rate? Bank investors, compelled by regulatory imperatives, will not have a choice but to pick up high quality assets with a punitively negative yield. Some investors with the flexibility may choose to seek yield outside the SSA sector.
One SSA banker said he's already observed some Taiwanese investors leaving the SSA sector entirely.
Moving to other asset classes is far from a soft option. Global defaults are at their highest since 2009, according to Standard & Poor's, and with China’s growth faltering and commodity (especially oil) prices low, 2016 promises more of the same.
The ECB can push ahead with its campaign to keep interest rates as low as possible to drive spending, but low profitability is a growing concern in the banking sector. Since regulators are unlikely to relax their requirements on the quality asset ratios any time soon, this concern is only going to become more serious. If the sector stagnates, all the loss absorbing capacity, capital adequacy and asset ratios in the world will be of little help.
The result may be that the ECB's purchase programme destroys the very buyer base that is the foundation of the SSA debt markets - investors in high quality, liquid assets. Some investors may well not be able to stand the prolonged yield compression. Some may move to markets they would never have considered before quantitative easing.
Quantitative easing is a bold and radical policy - though likely a prudent one given the global picture. But as with any bold step, there are attendant dangers. The market can’t take this medicine forever.