Here’s what traders are saying about ECB intervention
Italian 10-year yields are now down below 6.5%, that’s a full percentage point lower than on Wednesday. Market players suspect ECB intervention is behind the sizable move. Still, everyone is breathing a sigh of relief as we head into the weekend.
Nevertheless, problems remain. You may have seen the story on contagion’s spread to Slovenia. Their bond yields have reached a record high of 535 basis points. And they too must now pay 7% for 10-year money. I wrote in June that many felt that Slovenia had become the new problem child of the EU. As the first Eastern European country to join the euro zone in 2007, they were seen as a sign of the success of the European experiment. This has gone somewhat off the rails and now they are the next victim in the ever-widening euro zone death spiral.
Here’s what I hear some traders in Europe a friend recently spoke to believe. They expect the ECB or an ECB-funded EFSF to become the buyer of last resort of all euro-denominated government bonds, and to eliminate the spreads. The question is when. They say the worst case scenario is that the ECB moves only when a full-fledged bank run is about to begin. The best case scenario is that they move when ECB-approved PMs rule both Greece and Italy.
They also see that the quid pro quo will mean an inevitable reduction of sovereignty, but they understand that austerity alone will lead to disaster. There is a (small) signal of increased support for a change in European rules is possible to allow this. But these traders say that more likely Draghi will preside over the collapse of the currency which he is tasked to manage for the next 8 years.
That’s close to a verbatim report I got from Italy. Thanks for the update, Andrea. This is all very much in line with what I have been telling you for one year now. And I still think it will happen this way. But clearly the risk to asset prices is all to the downside and that means risk off.
Slovenia joined the EU in 2004 along with 9 other countries, Bulgaria and Romania were the last two countries to join in 2007. https://en.wikipedia.org/wiki/Member_State_of_the_European_Union
Slovenia joined the eurozone in 2007, not the EU. Read the text.
Oops. You are correct – they also joined the EZ three years later. My bad…
If they are going to go about just buying bonds whenever a country’s yields get too high, without any announcement, it will just turn into a game of Whack-a-mole.
Or more appropriately, Whack-a-yield.
Ed-There are 2 issues with this approach which I don’t understand.
1. Would the targeted interest rate (or spread) be the same for all countries? If not, on what basis would the targets be made? Why would one country be allowed to have an advantageous interest rate over another?
2. Is a license to print in an unlimited fashion legal under current German law?
How the ECB ultimately proceeds is still unclear. The contagion to Slovenia shows you that you have multiple problems running at the same time. And Slovenia only has a debt to GDP of 50%. I reckon the easiest way to do it would be to offer a blanket one size fits all yield cap so as not to discriminate. That would be very, very unpopular though because in the eyes of the hard money crowd this is just an invitation for free riders to spend to their hearts’ content. The ECB and the EU would then have zero leverage. Things would have to deteriorate a lot before you got there.
The Spanish proposal the Economist is floating makes sense and I will write this up at some point. But the point is to pick out a star pupil (not yet under IMF auspices). Spain fits the bill and it is big enough to make a difference. The ECB would back Spain selectively as a show that they are different and better. And then use Greece as a whipping boy to show that they are different and worse. The hope would be to coerce people into reforms:
https://www.economist.com/blogs/freeexchange/2011/11/euro-crisis-7
The problem here is Italy. Italy is too big to fail so if they don’t reform and their yields remain elevated, the ECB will be forced to intercede and buy up their debt. And the contagion would be bad. We see Slovenia out of nowhere when everyone including me was looking to Belgium. The Italians have a mountain of debt rollovers coming due as well. So that’s a politically unsustainable approach that moves to the wholesale rate cap.
As for the second question, the ECB has broad powers. They ALREADY are intervening have been doing so for months. Just look at how much ‘money printing’ they have done:
https://pro.creditwritedowns.com/2011/11/ecb-bond-purchases-rate-easing-italy.html
I put money printing in quotes because these are asset swaps i.e. bonds for reserves and the ECB claims it has done it in a sterilised manner anyway. So this is not really ‘money printing’ in the gold standard inflationary sense. (See Auerback on this: https://pro.creditwritedowns.com/2011/11/auerback-in-europe-national-solvency-first-then-aggregate-demand.html)
Finally, the Bundesbank was a lender of last resort for Germany. There is nothing in German law against this. On EU law, EVERYONE should read the actual Lisbon Treaty because it makes it more clear:
https://pro.creditwritedowns.com/2011/11/the-relevant-articles-of-the-lisbon-treaty-for-the-sovereign-debt-crisis.html
BTW, The German constitutional issues are with unsterilised purchases.
Thanks Ed. Is their a limit to sterilised purchases?
The limit is in terms of the available financial assets the central bank owns with which to conduct the sterilisation. If the central bank’s purchases are sterilised, it purchases financial assets with newly created ‘printed’ base money and simultaneously sells an equivalent amount of other financial assets it has on its balance sheet in exchange for base money.
Here there is no change in the monetary base but there is a change in the availability of financial assets in the private sector. By buying one kind of asset and selling another type of asset in equal quantity, the ECB is altering private portfolio preferences. It is creating an artificial scarcity in one asset class and an abundance in another. In a sense, this is like picking winners and losers in the same way a price target on one country’s government bond and no price target on another equivalent government bond from another country is.
That’s why all of this is politically controversial. The ECB wants to target inflation and promote price stability. They do not want to pick winners and losers or become entrenched in deeply political debates about who gets central bank largesse and who does not.
If we didn’t have this crisis, the ECB wouldn’t have to do any of this. However, we do have this crisis, largely because the euro zone structure is unworkable; after all you don’t see the same problems in the US, the UK, or Japan yet despite high debts and deficits. It’s not pretty.
I am still not clear about something. Suppose the ECB buys mispriced (due to ECB actions) Greek bonds with 100 million euro of newly printed money, and those bonds within a few months are worth half that amount. Hasn’t the ECB while technically sterilizing, in reality it put 50 million euro of unsterilized money into circulation in a stealthy way?
Thanks Ed. Is their a limit to sterilised purchases?
The limit is in terms of the available financial assets the central bank owns with which to conduct the sterilisation. If the central bank’s purchases are sterilised, it purchases financial assets with newly created ‘printed’ base money and simultaneously sells an equivalent amount of other financial assets it has on its balance sheet in exchange for base money.
Here there is no change in the monetary base but there is a change in the availability of financial assets in the private sector. By buying one kind of asset and selling another type of asset in equal quantity, the ECB is altering private portfolio preferences. It is creating an artificial scarcity in one asset class and an abundance in another. In a sense, this is like picking winners and losers in the same way a price target on one country’s government bond and no price target on another equivalent government bond from another country is.
That’s why all of this is politically controversial. The ECB wants to target inflation and promote price stability. They do not want to pick winners and losers or become entrenched in deeply political debates about who gets central bank largesse and who does not.
If we didn’t have this crisis, the ECB wouldn’t have to do any of this. However, we do have this crisis, largely because the euro zone structure is unworkable; after all you don’t see the same problems in the US, the UK, or Japan yet despite high debts and deficits. It’s not pretty.
I am still not clear about something. Suppose the ECB buys mispriced (due to ECB actions) Greek bonds with 100 million euro of newly printed money, and those bonds within a few months are worth half that amount. Hasn’t the ECB while technically sterilizing, in reality it put 50 million euro of unsterilized money into circulation in a stealthy way?
“Spain fits the bill and it is big enough to make a difference. The ECB would back Spain selectively as a show that they are different and better. And then use Greece as a whipping boy to show that they are different and worse.”
I’m having a hard time reconciling this with what Michael Pettis writes (e.g. Germany Must Do It, Not China), what Martin Wolff writes (e.g. Creditors Can Huff, But They Need Debtors) and what you write (e.g. The Euro Zone is One Giant Vendor Financing Scheme)
I am telling you what I think could happen. I am not advocating it. You have to separate the two. The Germans want to pressure countries on the fiscal front. This is one way to do it.
As long as there is no growth the situation will deteriorate (the same for any OECD nation tbh), doesn’t matter if they are or aren’t currency issuers, printing money gets you ‘that far’ if you don’t have appropriate transmission channels (and the only remotely appropriate channel is fiscal policy).
What’s the long term plan here Edward? Central banks owning every single debt security in the world? And can they do it only through reserves? (I though ECB interventions where directly in the secondary market, the same on currency interventions from BoJ or SNB, they actually inject liquidity into the system)
I don’t think this is non-inflationary as MMT crowd suggests, liquidity at some point will be channelled somewhere and that will create inflation. There is an excess of net financial assets already in the system, we don’t really need more, what we need is production, productivity, income, jobs and efficiency and no more financial shenanigans. You can already see it, we are on the verge of a new recession (or deepening of the first depression in this century) and crude oil is almost at USD 100. Not looking good… and reducing the possible assets to invest in won’t do it better.
IMO we are approaching a dangerous combination of deflation and inflation by reckless intervention with the wrong policies in mind which will make the system collapse in a non too distant future (maybe we can kick the can for some more years, but not much more). And still, this system can’t work without growth…
Any thoughts?
Leverage’s comment above is exactly right about growth… without it, having the ECB as the lender of last resort only prolongs the pain (whether in Italy, Greece, Portugal, etc.)… Unfortunately, not many reports (even the IMF/WB recommendations) truly address this issue… increasing productivity in context of ageing populations, secular declining growth, entranched social norms, and vested interests is no easy task… and it goes way beyond politicians’ ability to effect real change in behavior…
Pettis’ post was interesting in that it showed Germany running trade deficits and then flipping to surpluses in a couple of years… In other words, there are policies that can be implemented to redress trade imbalances.
Maybe Merkel could legislate a mandatory Happy Hour from 10pm to 2am in Germany…