More thoughts on yield ceilings on euro zone sovereign debt
This is just a quick follow-up to my article on ECB sovereign debt yield caps. I don’t think the ECB is about to put ceilings on euro area sovereign debt yields. The speculation generated by the Spiegel article is not warranted in my view. Yes, the ECB is probably considering all possibilities in its contingency planning. But putting ceilings on sovereign debt is unlikely to be one of the choices it chooses to implement in the near future in my view.
What’s more likely? Well, think about the Fed, for example. As the US financial crisis progressed, the Fed did one round after another of liquidity operations. The Fed is known to also have considered numerous options to deal with the US banking and mortgage crisis including rate caps and buying municipal bonds.
As the Fed pondered whether to ease again last year, I predicted that the Fed would start a third easing campaign. But I also said that so-called quantitative easing, where the Fed vastly expands its balance sheet via quantitative buying targets was out because it was a controversial (and ineffective) way of easing. Instead, I said that the Fed would look at rate caps aka rate easing and that it would only move to do so slowly (see added bolding for emphasis):
When it comes to quantitative easing, we have to look both at the quantitative and the easing. Going back to the Fed’s failure to reduce longer-term interest rates during QE2, it has more to do with the quantitative than the easing. Ultimately, one can influence the price or the quantity of something, but not both. And with QE2, the Fed decided to influence the quantity (of bank reserves), when its stated aim was to influence price (of money reflected by interest rates).
It is unlikely that the Fed will go back to the well for the same policy since QE2 has proved ineffective. So now that the economy is weak again, it will up the ante and target rates instead of specific easing quantities. This has the potential political benefit of the Fed’s not having to expand its balance sheet. The Fed would essentially guarantee a rate and let the markets move interest rates to that level. Of course, the Fed would promise to defend the rate(s) if and when necessary. The Fed may be tested initially, but punters would lose their shirts fighting a market player with a potentially unlimited supply of liquidity. So I would expect the balance sheet effects for the Fed to be muted. And clearly, if QE3 reduced rates in addition to having largely the same impact as QE2 as well, it would be a more powerful tool.
There could be internal dissent to such an aggressive policy. I do not expect QE3 now nor do I expect it unless the economy deteriorates further. So the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Look for how the Fed reinforces its commitment to “exceptional low levels for the federal funds rate for an extended period”. If Bernanke is forceful about this commitment in this week’s FOMC press conference, people will be forced to accept the likelihood of permanent zero and the term structure will flatten further and further out the curve.
This is exactly what happened. And the key here is the political consideration. The Fed does not want to be seen overstepping its mandate and engaging in an excessive amount of quasi-fiscal operations. So it has limited itself willingly.
The ECB faces similar political constraints. For that reason I believe the ECB will not engage in rate easing any time soon. Rather, the ECB will soft pedal its moves. As Nomura points out, “unconditional yield targets across countries look very unlikely”. Instead, the ECB is more likely to do something at the short end of the curve only for those countries that officially request financial aid from the Troika. People seem to forget that this actually was the storyline just a week ago.
If you recall, Mario Draghi talked a lot about doing “whatever it takes” to stem the crisis – and punters were disappointed when the ECB basically did nothing at the next ECB meeting because Draghi’s comments about the ECB doing “whatever it takes” became irrelevant. However, at the press conference, Mario Draghi hinted at the “unlimited” option that I have been discussing for quite a while now. And some people took this to mean that he was about to go ahead and do it. The Spiegel story only confirms those rumours. It’s good to see yields come down but I believe the rumours are false and that the “unlimited” option is only a backup plan in case of emergency.
My baseline, however, is for a disorderly breakup. Greece will exit the euro zone and this will be a disorderly event. In my view, this could actually make it more likely that we will see monetisation because, like the Lehman crisis, the panic will make people look to stem the tide of debt deflation by any means necessary. So I still believe the ECB will eventually go in guns blazing but it may not happen until Greece leaves the euro. In the meantime, expect policy paralysis in Europe.
Baby steps. Break glass only in case of emergency.