Germany's bond shortage is finally easing

Two-year Bund swap spreads blew out towards 100 basis points at the height of the collateral squeeze in 2022, as traders paid steep premiums to borrow physical German government bonds. For the better part of seven years the European repo market suffered from an artificial shortage of Bunds. The European Central Bank's quantitative easing had hoovered up hundreds of billions of euros of high-quality government paper, leaving banks and hedge funds without enough top-grade collateral to settle repo trades. As 2023 begins, the shortage is finally easing.

Fiscal and monetary policy are both moving the right way. First, the German federal government has sharply expanded its borrowing programme to pay for large domestic energy subsidies, sending hundreds of billions of euros of new bonds straight through the primary dealers.

How the squeeze built

The shortage began with the ECB's public-sector purchase programme in 2015 and deepened with each round of buying since. Germany, meanwhile, ran budget surpluses for much of the late 2010s under its constitutional debt brake, so the stock of Bunds grew slowly just as the central bank was absorbing them. The ECB recognised the problem early, and in December 2016 it began accepting cash as collateral when lending out the bonds it held, a first attempt to put paper back into the market.

The squeeze came to a head in 2022 for a new reason. Once rate rises began, investors wanted safe, short-dated collateral to park cash and to post as margin on derivatives, and energy traders facing huge margin calls on gas and power futures added to demand for the same bonds. The supply of free-floating Bunds could not keep up.

Why swap spreads blew out

A swap spread measures the gap between the fixed rate on an interest-rate swap and the yield on a government bond of the same maturity. When Bunds are scarce, investors bid up their price to get hold of them, pushing yields down relative to swaps, and the spread widens. At close to 100 basis points, the two-year spread meant investors were giving up a full percentage point of yield for the privilege of owning German paper.

That premium leaked into everything priced off Bunds. Corporate treasurers hedging euro borrowing, pension funds matching liabilities and banks managing their own rate risk all paid for a distortion that had nothing to do with German credit risk.

The ECB lets go

Second, the ECB has begun to unwind its hoarding of collateral. It has raised the limits on its securities lending facility and increased the rate it pays on government cash deposits, which removes the incentive for national treasuries to park cash at the central bank when they could lend it in the private repo market.

The coming start of ECB quantitative tightening, which will phase out reinvestment of maturing APP bonds at €15 billion a month, should also return a steady flow of physical collateral to the private financial system. A change to its long-term lending programme in October has helped too. Banks that had pledged bonds against cheap ECB loans have repaid hundreds of billions of euros early, freeing collateral that had been locked up at the central bank.

Swap spreads come back in

As collateral markets return to normal, Bund swap spreads are narrowing fast towards their historical ranges. That puts the euro benchmark curve back in working order, so corporate bond issuers and institutional hedgers can price interest rate risk without paying an artificial collateral premium.

It also steadies cross-currency basis markets, where European banks had struggled to raise dollar liquidity against government collateral. The losers are the funds that held Bunds as a scarcity trade, betting that the premium would persist; as supply rises, that premium drains out of the price.

The supply itself is not in doubt. Berlin has set up a €100 billion special fund for its armed forces and a €200 billion shield against energy costs, both financed largely outside the normal budget and both requiring new borrowing. A government that barely added to its debt for most of the past decade is now borrowing heavily.

Why the fix may be slow

The strongest objection is that the ECB is letting go only gradually. The planned run-off covers part of its older programme, while reinvestments from its pandemic programme are set to continue until the end of 2024, so the central bank will remain the largest holder of Bunds for years. The warm start to the winter may also mean Germany spends and borrows less than it planned on energy support, trimming the new supply that dealers had expected.

Scarcity can also return in bursts. Quarter-ends and year-ends, when banks shrink their balance sheets, have repeatedly pushed German repo rates far below the ECB's deposit rate, now 2 per cent, and those episodes may recur even as the average improves.

What to watch

The first milestone is the start of quantitative tightening in March, followed by the German finance agency's quarterly issuance calendars, which will show how much new paper reaches the market. Repo rates on German collateral around the end of March will test whether the plumbing has really improved. A two-year swap spread that stays well below its 2022 peak through that quarter-end would confirm the turn.

With German collateral flowing again, the distortion that hobbled European money markets for nearly a decade should fade over the course of 2023, and euro borrowers and hedgers will stop paying a scarcity tax on their trades.