Monthly Archives: May 2012

So, the German federal treasury is issuing zero-coupon two year bonds (FT Alphaville). While technically the yield to maturity is anticipated to be marginally positive (they are expected to sell very slightly below face value), it’s an interesting position to be in. The real yield is significantly negative, a borrow 100 today, repay 95 in two years’ time kind of deal if we expect 2-3% inflation in Germany.

The German finance minister doesn’t want to borrow much more from where the Federal Republic stands (which is average by Western country standards). But what about doing a carry trade: supply unlimited liquidity at a fixed 0% (or 0.25) to whoever wants some, deposit the proceeds at the ECB (via the Bundesbank), and collect 1% base rate from the ECB. Not only is the risk essentially nil — in the worst case scenario the ECB can only take the rate to zero if it had to face strong deflationary headwinds — and it has no impact on the Federal Republic’s debt situation because, if these bonds are balanced by ECB cash deposits, they do not add to the country’s net debt.

They can issue as much of this as the market will take, there’s no limit given that it’s a risk free trade. The question is then how much would the market take if they made that offer? In times of collateral shortages and given the lack of direct ECB-backed paper it, might be quite a lot. The proceeds of the carry trade, the 1%, could be redistributed to Eurozone growth/bail out funds. In addition it contributes to helping solve the worldwide quality collateral shortage issue.

The ECB could gently conspire and put the base rate up to 1.5 or 2% to increase that return, which is probably not going to hurt anyone much in the real world — after all the current problem is largely that the banking system is in such a state that it doesn’t respond much to rates, and the price of real loans is likely dominated by the risk spread rather than the base rate component. It would hurt the LTRO  peripheral bank sovereign carry trade profits a bit, as they are on a floating rate, but probably not to the point of taking them underwater, and then this flow of ECB money may find a better home channelled via the public purse than via private hands.

There could be an argument that it would squeeze out the demand for other euro-area countries’ own bonds, but then at the current juncture most of the others’ bonds have become risky assets while the German bond is a proxy risk-free reference asset for lack of a better one within the Eurosystem. So basically they are marketed at different groups of buyers and not substitute for each other anymore, so squeezing out is unlikely to matter.

There might be other side effects that I have not thought of, and the actual demand may be too small to matter — if the potential issuance was say 500 billions, free money of 5 billions a year is nice to have but not life changing — but the idea is intriguing.