Central Bank-Driven Mispricing

Abstract

We show that bond purchases undertaken in the context of quantitative easing efforts by the European Central Bank created a large mispricing between the market for German and Italian government bonds and their respective futures contracts. On top of the direct effect the buying pressure exerted on bond prices, we show three indirect channels through which the scarcity of bonds, resulting from the asset purchases, drove a wedge between the futures contracts and the underlying bonds: the deterioration of bond market liquidity, the increased bond specialness on the repurchase agreement market, and the greater uncertainty about bond availability as collateral.

The importance of being special: Repo markets during the crisis

“…Our previous findings of a deterioration in bond market liquidity of the 10−year on-the-run bonds when purchased by the ECB are clearly important for the price-discovery mechanism between the cash and futures markets. A larger bond bidask spread would lead to a larger range of possible relative cash bond prices when compared with the futures prices leaving market participants uncertain on the true price (see also Pelizzon, Subrahmanyam, Tomio, and Uno, 2018). 49 [Insert Figure 6 near here]…”

The Eurosystem's Asset Purchase Programmes, Securities Lending and Bund Specialness

“…This view was later corroborated by academic research conduceted byPelizzon et al (2020) during that period. 14 Market contacts indicated the low repo rates led to market entries of strategig Bund investors in the Bund repo market.…”

The Scarcity Effect of Quantitative Easing on Repo Rates:

“…This occurs not only at the short end of the yield curve but also at the long end, as long as scarcity prevails. For instance, Pelizzon et al (2018) also show how scarcity distorts the price of other types of instruments such as futures contracts.…”