LONDON (Reuters) - The European Central Bank may well be printing money via its landmark government bond buying program, but it could also be destroying some of the financial system's own printing presses in the process.
Little over a week after the ECB launched its 1 trillion euro 'quantitative easing' campaign, financial markets are fretting that there is a shortage of bonds for the central bank to buy.
This has created a hiatus in the plumbing of the global financial system that's seen bond yields and long-term interest rates vanish across the spectrum and move deeply negative in some cases, especially benchmark German bunds.
ECB officials insist this 'scarcity', rather than shortage, is a deliberate part of QE and forces down yields on the lowest risk bonds in order to push banks and investors into riskier lending more useful to the economy.
But the stimulus to cash flows around financial markets rather through the high streets has been far more seismic.
"ECB QE will not have a significant effect, at least in our view, on the real economy - but it is having a massive effect on financial markets," said Phil Poole, head of Research at Deutsche Asset & Wealth Management.
"There is clearly a distortion in the market which is leading investors generally to take more risk or buy less liquid assets in order to generate a return."
Some experts beg to differ with the ECB and say a growing shortage of top-rated bonds, particularly AAA-rated German bunds, is playing havoc with the way the financial system generates money within itself by the pledging and re-pledging of top quality bonds as collateral in return for cash.
Any shrinkage of this securities lending market, a giant moneyspinner with 5.5 trillion euros outstanding in Europe alone, has been a concern ever since the global credit crisis and subsequent regulation cut the range of bonds and counterparties involved, and limited the amount of times bonds are typically repledged for cash.
For example, a drop in the re-use rate of collateral in this way from about 3 times to 2.4 times over the four years after the crisis involved an evaporation of $5 trillion in the cash generated by banks, according to IMF estimates.
The concern is that QE, by draining markets of the top-rated collateral itself, has a similar effect and offsets the intended injection of new cash into the banking system.
As a result, the ECB's 1 trillion euro cash creation could be dampened by the net removal of bunds and other government bonds that can raise more than twice their face value in cash via repo markets.
The particular squeeze on the benchmark German bund market from the ECB buying plan, which according to its so-called 'capital key' formula targets more bunds than the likes of Italian or Spanish government bonds, has driven yields on about of a third of euro government bonds into negative territory.
JPMorgan analysts estimate that as ECB kicked off QE last week, almost 4 percent of 4.6 trillion euros of government bonds between the targeted 2 and 30 year maturities - and as much as 20 percent of the 800 billion euros of German bunds in this area- had negative yields greater than 20 basis points.
Given that the ECB is not even able to buy bonds with negative yields any larger than 20bp, then the skew in supply and demand is pretty obvious and yields on longer-term bunds have sunk further too on the assumption that the shorter-term paper is already too negative to be eligible for ECB bond buying.
"The stock of bonds eligible for ECB purchases is diminishing as a result of the price action, a self-reinforcing but unstable dynamic," Goldman Sachs economists told clients.
Driving this is the fact that, unlike the Fed's QE program, the ECB will be buying more euro governments bonds than the amount of new bonds being raised by euro capitals over the period of the purchases. Barclays estimates the overall effect will be to remove a net 560 billion euros of government bonds from investors, or shrink the market by that amount.
Claiming German bund market liquidity dried up considerably last week, the JPMorgan analysts wrote: "The ECB not only creates scarcity of one form of collateral versus another but it also creates shortage of collateral by replacing high efficiency government bond collateral with lower efficiency cash collateral."
The ECB has said it will lend back key securities to the market if stress occurs in particular areas of the bond market, but analysts reckon this would likely involve the exchange of one scarce bond for another and not change the collateral pool materially. Few expect the ECB to cut its campaign short either, at least not in the absence of it getting inflation back to the 2 percent target early.
Perhaps the effect of pushing banks and asset managers out of such deeply negative yields into long-dated and riskier debt, equities and even foreign bond markets - hence weakening the euro - may simply be seen as the main prize. The near 25 percent drop in euro/dollar since the middle of 2014 shows that's well on the way.
"The principle impact on the real economy is through the exchange rate and that's what we are seeing," said Poole at Deutsche AWM.
Additional reporting by Nigel Stephenson; Graphics by Vincent Flasseur; Editing by Tom Heneghan