More on the ECB’s using redenomination risk as the rationale for intervention

A while ago I posted a translation of Joerg Asmussen’s Frankfurter Rundschau interview and my interpretation of his commentary. Here is the rest of the translation and some commentary.

There are to be bond purchases once more. What makes you think the new programme will be more successful than the first two programmes, which only reduced rates in the short term?

Because it will be better conceived than the old bond-buying programme, the SMP.

You’ll have to clear that up a bit more.

The ECB will only be active in parallel with the EFSF, or later the ESM. A state must make a request and carry out comprehensive economic reforms. In my personal view, it would be good to demand that a request for primary market intervention by the EFSF/ESM must be made before the ECB will be active. Such a request is but a necessary condition for the intervention of the ECB. The ECB council will decide with full independence if, when, and how bonds will be bought in the secondary market.

Bundesbank president Jens Weidmann provided the lone vote against the new programme. What does Jorg Asmussen see that Jens Weidmann doesn’t?

I didn’t attend the meeting because of a vacation.

Do you share the doubts of Bundesbank chief Weidmann?

Jens Weidmann and I, we talk with each other, not over each other. The cooperation is close and trusting, but also confidential, just like the Grand Coalition of the good old days. (NB reference to times the CDU/CSU and socialists have worked together)

The Bundesbank is concerned that the ECB’s mandate will therefore be overridden. Are they right?

We’re acting within our mandate, the priority of which is aimed at guaranteeing price stability for the euro area as a whole. Only a currency about which there are no doubts to its survival can be stable. That’s what we’re working for at the ECB.

This translation was provided by FT Alphaville. What it makes clear is that the ECB will start buying up peripheral debt. So, it’s not a question of whether they will or not. They will. The question is which countries they are targeting and which maturities.

My read here is that the ECB is looking to disaggregate the risk premia in order to eliminate the redenomination risk for countries for which that risk is unwarranted or illegitimate. That means the ECB will back countries that comply fully with a Troika-mandated rescue program by either capping yields or buying bonds in concert with the bailout facilities. We are talking only about Spain and Italy here. Greece is not a case for illegitimate redenomination risk if they are incapable of meeting the terms of their Troika rescue packages. That’s the inference Asmussen makes from his commentary. He is saying that even Greece will receive support if they pull it together. But the ball is in their court.

Now, obviously the ECB does not want to go all in yet. So I believe they will attempt to pull this off by at first by only buying bonds of countries that apply for Troika bailouts in concert with the European bailout funds up to three years maturity. As Draghi said before and Asmussen says in the translation above, the EMF/EFSF will buy on the primary market and the ECB will buy in the secondary market. There is no talk here about ESM banking licenses. Importantly, I don’t believe the ECB will look to cap yields or buy long-dated paper. Just like the Fed, the ECB will take increasingly drastic action only in measured steps.

Eventually, this may not be enough. But the ECB is hoping that it is in concert with Spain and Italy’s successfully hitting Troika targets, this will be enough. Ireland is the model case here because their yields have come way down to almost sustainable levels in the two and three-year area because of their successfully hitting targets. Lorcan Roche Kelly pointed out on Twitter that “since June 1 the yield on Irish 2 year debt has moved from 7.405% to 2.58%.”

If these efforts are insufficient, that’s when unlimited purchases or yield caps would come into play. The ECB are looking to disaggregate the risk premia. The only way to eliminate these risk premia without eliminating the others (inflation, default, foreign exchange, etc) is to target spreads and not absolute yields. Remember, the ECB’s rationale for interfering is “incomplete” monetary policy transmission due to redenomination risk.

Watch what the ECB says next month. This will be their rationale for interceding.

As for bond vigilantes, look at what has happened to yields with just the rumour of ECB going all-in. They have collapsed. What happens when the ECB actually does go all-in? If they target spreads, the yields will move to those spreads. Being a so-called bond vigilante and trying to buck this trend is a recipe for losing a lot of money. But the ECB is not going to target yields. They will just offer to buy unlimited amounts at specific maturities. The key though is the word unlimited. If this “unlimited” threat is real, bond vigilantes will have to give up and lick their wounds as the ECB buys two and three year paper and holds these bonds to maturity. This is what’s about to happen.