The market stabilisation role of the pandemic emergency purchase programme

Blog post by Philip R. Lane, Member of the Executive Board of the ECB

March 2020 was a pivotal month in the escalation of the economic and financial dimensions of the pandemic crisis.^[1] As it became clear that the scale and speed of the spread of the virus required very extensive lockdown measures around the world, there was a sharp downward revision in the economic and financial outlook that was paired with extremely elevated uncertainty. The global financial system was put under extraordinary strain. The nature of the shock triggered an abrupt and significant desired rebalancing of portfolios, in the direction of greater liquidity and lower leverage. The collective scramble to implement this portfolio shift, with investors all looking to make similar trades, put pressure on market-making financial intermediaries and was associated with a widespread dash for cash. This ran the risk of forced fire sales in many asset markets, illiquidity spirals (with the joint loss of market liquidity and funding liquidity) and the discontinuities associated with market freezes.

Under these conditions, liquidity provision and asset purchases by central banks can limit self-fulfilling overshooting dynamics and the associated risks to financial stability. Generous access to central bank refinancing facilities enables intermediaries to tap liquidity without having to sell their asset holdings. Asset purchases by the central bank (of both sovereign and private-sector securities) have a reach that goes beyond the provision of liquidity to banking intermediaries, by acting as a counterweight to one-sided market pressures. In particular, asset purchasing by a central bank “crowds in” other investors by providing the reassurance that self-fulfilling market instability risks will be contained by the stabilising presence of the central bank.

In a monetary union that lacks an area-wide common safe asset, flight-to-safety episodes also have a geographic dimension, in view of the high substitutability across national financial systems that is generated by the absence of currency risk. The nature of such episodes is that heightened risk aversion not only involves a reassessment of the pricing of fundamentals-based risks but also may induce a withdrawal to so-called safe haven jurisdictions in the belief that other investors may also opt to make the same geographic reallocation decision.

In the absence of active market stabilisation by the central bank, the intrinsic self-validating nature of flight-to-safety dynamics creates the risk of asset price movements and cross-border financial flows that, in terms of their magnitude, are unwarranted by fundamentals, but that also reflect a switch across multiple self-fulfilling beliefs-driven equilibria.

While it is always challenging to distinguish between fundamentals-driven and beliefs-driven repricing and reallocation dynamics (especially in real time), the specific circumstances of the pandemic crisis suggest that there was a compelling case for the central bank to act as a market stabiliser. First, as outlined above, it was clear that flight-to-safety pressures were operating at a global level, with the risk of a broad disconnect between asset prices and fundamentals across many markets. Second, the nature of the shock (a worldwide pandemic) meant that concerns about moral hazard were more attenuated than in some other scenarios.

In response, the ECB acted through its liquidity operations and the setting-up of the pandemic emergency purchase programme (PEPP). The PEPP has a dual role. First, together with the other components of the monetary policy framework, extra asset purchases are an important mechanism to deliver the monetary accommodation required to ensure that medium-term price stability is protected by supporting the economic recovery from the pandemic crisis. Second, the flexible nature of the PEPP across time, asset classes and jurisdictions is designed to fulfil the market stabilisation role in an efficient manner, especially in view of the high uncertainty associated with the effects of the pandemic across different asset markets and the individual euro area countries.

It is now three months since the PEPP was launched. With last week’s release of the April data for the balance of payments, it is now possible to look back and review some of the data from the pre-PEPP and initial post-PEPP phases.

Chart 1 plots the composite indicator of systemic stress (CISS) in the euro area financial system. The CISS clearly shows a sharp increase in systemic stress in the first half of March of this year.

In relation to private securities, Charts 2 and 3 show the adverse dynamics of corporate bond yields and the stock market index during this period. The market stress also extended to the interbank market, as illustrated by the behaviour of the EURIBOR in Chart 4.

Chart 5 shows the output-weighted average ten-year sovereign bond yield, expressed in terms of the deviation from the ten-year overnight index swap (OIS) rate. Sovereign bond yields are central to determining financial conditions in each Member State: Charts 6 and 7 show the high correlation between the funding conditions facing banks and corporates and sovereign bond yields. Accordingly, the widening in the gap between the average sovereign yield and the OIS rate in March suggested that fragmentation pressures were increasing. This is reinforced by the pattern in Chart 8, which shows an increase in the contribution of a segmentation indicator in accounting for the joint behaviour of sovereign yields during this period.^[2]

Across these various asset price indicators, the common pattern is that of a significant de-escalation in market tensions after the mid-March market stabilisation measures taken by the ECB (PEPP; refinancing operations; collateral-easing measures). Since Chart 9 shows that the macroeconomic projections continued to deteriorate throughout April and May, the improvement in market conditions cannot be attributed to a general boost in the outlook. Rather, it is plausible that central bank interventions played an important contributory role. In the euro area context, the further improvement in conditions in recent weeks can also be attributed to the increasing likelihood of an EU-level fiscal response to the crisis that will act to contain the tail risks facing individual member countries.

As is displayed in Charts 10 and 11, the March and April balance of payments data show a basic asymmetry across the member countries of the euro area. If the member countries are divided into two groups (less vulnerable and more vulnerable), the March data show that cross-border investors were net sellers of the debt liabilities of the more vulnerable group and net buyers of the debt liabilities of the less vulnerable group. This configuration is consistent with the nature of a flight-to-safety episode. Although this basic pattern is also found in the April data, the extent of the net selling of the debt liabilities of the more vulnerable group is much less severe than in the March data.

Across both groups, another feature of high-stress episodes is clear in the March data: net sales of foreign assets by domestic investors. However, this proved to be quite short-lived, with the April data showing the more typical pattern of net purchases of foreign assets (especially for the less vulnerable group).

More insight into the reallocation decisions of euro area investors can be obtained by examining the shifts in the securities holdings of the various investor categories in the first quarter. Chart 12 shows that the vast bulk of the net portfolio disposals were attributable to the investment fund sector (with a relatively smaller contribution from insurance companies); in contrast, banks (monetary financial institutions – MFIs) played a counterbalancing role and were net acquirers of debt securities during this period. The relative stability of the investment positions of other sectors compared with the investment fund sector has been recognised in a variety of contexts.^[3]

In turn, Chart 13 shows that the primary sectors disposing of investment fund shares were other investment funds (illustrating the interconnected nature of the investment fund sector) and insurance companies. The primary role of institutional investors in the sell-off is also clear in Chart 14, which shows that flows into retail funds were relatively more stable than flows into institutional funds. Chart 15 further confirms that the disposals of investment funds were especially concentrated on debt securities.

Charts 16 and 17 show significant differences in sectoral portfolio patterns across the groups of less vulnerable and more vulnerable member countries. While banks in both groups operated in a countercyclical manner, the scale of portfolio disposals by insurance companies in the less vulnerable group is especially striking. While nearly all sectors in the less vulnerable group pulled back from holding the debt issued by other euro area countries, several sectors in the more vulnerable group also disposed of domestic debt securities (including households and investment funds).

Taken together, Charts 10-17 capture the heterogeneity across sectors and across country groups in relation to portfolio reallocations during the first quarter. With the stabilisation of markets, we should expect to see some reversal in these patterns in the second quarter data when these become available.

In conclusion, the evidence shows that the ECB has contributed to market stabilisation. In asset markets, the significant impact of the announcement of the PEPP (together with the contributions from our other liquidity-easing measures) is consistent with a crowding-in role by which central bank intervention minimises the risks of a beliefs-driven self-fulfilling switch in equilibria. In the balance of payments data, the April monthly data show a pull back from the remarkable shifts seen in the March data.

Under the counterfactual scenario in which the central bank did not act forcefully, the pandemic shock would have been amplified by financial instability. Avoiding this outcome (which also would have been very adverse in terms of its implications for medium-term price stability) has been a central objective for the decisions of the ECB Governing Council. At this point, the future path of the pandemic and its economic implications remain highly uncertain. So it is appropriate that the Governing Council has indicated that net purchases under the PEPP will continue for the next 12 months and, in any case, until the Governing Council judges that the coronavirus crisis phase is over.