Investor expectations of further monetary easing from European Central Bank President Mario Draghi have pushed yields on more than $2 trillion of eurozone government securities below zero.
Bonds across the region climbed last week when Draghi said the institution will do what’s necessary to rapidly accelerate inflation. The statement, which recalled the language of his 2012 pledge to do “whatever it takes” to preserve the euro, solidified investor bets on further stimulus at the ECB’s Dec. 3 meeting. The single currency weakened to a seven-month low on Monday after futures traders added to bearish bets, Bloomberg reported.
A 10 basis-point cut in the deposit rate is now fully priced in, according to futures data compiled by Bloomberg, while banks from Citigroup Inc. to Goldman Sachs Group Inc., are predicting an expansion or extension of the ECB’s €1.1 trillion ($1.2 trillion) quantitative-easing plan.
“The ECB is doing little to counter this market speculation,” said Christoph Rieger, Commerzbank AG’s head of fixed-income strategy in Frankfurt. “Should they not deliver now it would clearly cause a huge backlash with regards to the euro and overall valuations.”
Negative-yielding securities now comprise about one-third of the $6.4-trillion Bloomberg Eurozone Sovereign Bond Index. The amount compares with $1.38 trillion before Draghi’s Oct. 22 press conference, where he pledged to reexamine stimulus at the institution’s December meeting.
Germany’s 10-year bund yield was little changed at 0.49%. The price of the 1% security due in August 2025 was 104.82% of face value. The yield on the nation’s two-year note touched a record low minus 0.39%.
Yields below zero mean investors who buy the debt now and hold to maturity will receive less than they paid, accepting the penalty in return for the investment’s relative safety.
Leverage Limitations
European banks will become more stable with the introduction of limits on leverage if the levels aren’t set too high, research by the European Central Bank showed.
A leverage ratio, which isn’t weighted for risk, and existing risk-weighted capital requirements will complement each other, making the banking system more reliable, according to a study published Monday as part of the ECB’s Financial Stability Report. The benefit starts to fade when the leverage ratio reaches about 5%, authors Michael Grill, Jan Hannes Lang and Jonathan Smith wrote.
Global regulators added a cap on how much debt banks can take on relative to their assets after the 2008 financial crisis. The Basel Committee on Banking Supervision is testing a non-binding leverage ratio of 3% of assets, which is expected to be recalibrated and turned into a binding requirement by 2018.
The rationale for introducing a leverage ratio (LR) is that risk weights appeared to be unreliable or even manipulated in the crisis, leaving banks with insufficient capital in distress. However, policy makers including Sweden’s Finansinspektionen financial regulator have warned that risk-insensitive capital requirements could lead to a less stable system.
“Increasing the LR from low levels seems to be of considerable benefit to bank stability, but as a bank’s LR reaches around 5%, the benefits of increasing it further start to diminish slightly,” the researchers write. “There may be considerable benefit in introducing the LR requirement with a modest calibration.”
The ECB studied the impact of adding the leverage ratio to the risk-weighted capital requirements both in a theoretical model and based on financial data for 500 banks in the European Union from 2005 to 2014.
The model shows that while banks have an incentive to take on slightly riskier assets, which is more than offset by the additional capital banks have to raise to meet the ratio.
A one percentage-point increase in a bank’s leverage ratio reduces the probability of distress by 35% to 39%, according to the study. By contrast, the same increase in risk-weighted assets, increases the risk by 1% to 3.5%.
