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.

As I told subscribers last week:

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.

  1. Dave Holden says

    Since the only way monetary union is economically sustainable is politically unsustainable then break up seems inevitable. Sustainable being the key word here, lots of things can be done on an unsustainable basis, a fact that in a ideal world the powers that be would use to facilitate an orderly breakup.

    1. Edward Harrison says

      Orderly? Ha. Your analysis is right that politically feasible and economically sustainable solutions don’t necessarily overlap. That’s why I have stopped thinking policy makers actually will take hard choices. Let’s see what the ECB does. I am looking for liquidity as a quid pro quo for bailouts, a more advanced version of the existing policy.

      Baby steps.

      1. Dave Holden says

        Well more orderly…


        What I expect is increasingly expensive can kicking accompanied by ever increasing democratic deficits until either a creditor or debtor nation’s voter/political class snaps.

        At that point all bets will be off and I just hope they collective have a plan to deal with the ensuing crisis.

        1. David_Lazarus says

          Yes the can kicking has already lead to the main political parties in Eastern and southern Europe suffering. Hungary is moving to the Right. Extremist parties will have a resurgence thanks to Merkel. The electoral interference by Merkel in Greece will possibly comeback to haunt her.

  2. David_Lazarus says

    I do not see an orderly break up as an option. Greece as the most likely to exit will mean that the banking system there will collapse, and any debts in euros will be unrecoverable. Once other nations see that, then there could be a stampede to exit the euro and wipe out the debts that are crippling the economy. Banks everywhere are the problem and this might be what is actually needed to clear out the debt burden that is crippling most economies. There will be no debt jubilee but plenty of bankruptcies and that will clear the debts rapidly. The losses at German banks will mount and then the German government will probably fall.

    1. Dave Holden says

      I’m not sure about a stampede, for debtor nations there will surely be a tension between staying and facing the prospect of devaluation on leaving.

      1. David_Lazarus says

        All the nations want to stay but it the pain of staying becomes unbearable then they will leave. The fact that exit has even been considered means that the markets will now test the politicians willingness to stay in the club. Even Greece wants to stay in but the imposition of the austerity to protect the creditors will test the politicians. The stampede may be some years away but it could all happen very quickly.

  3. pr says

    Thanks, always thought provoking stuff. I have a few comments:
    – I am not sure you can say QE2 was ineffective without knowing the counterfactual;
    – QE (ie. increasing broad money, M3 in USA and EUR and M4x in UK) for Europe is difficult to execute through the government bond market as in many regions the government bonds are not locally owned and therefore the ECB will not be able to target broad money growth locally (eg. c10% Irish government bonds are owned by the Irish – buying their bonds won’t increase M3 in Ireland). Therefore a government bond buying program is really just limited to a liquidity management tool (which I think you allude to anyway) as per QE1 in the US.
    – I was previously of the view that ECB would start monetising debt only in an extreme downside scenario. After reading this interview with Schaeuble on Spiegel where he mentions the high likelihood of a referendum in Germany (page 2),….I have changed my mind Good night Europe.
    – As a slide aside, I was told an interesting story about a Gilt issue in England in 1914 whereby the BOE failed to get the issue fully subscribed and instead of spooking the market, the Chief Cashier and his Deputy took out a loan from the BOE and subscribed to the undersubscribed portion personally. The loan was classified as “other securities” in order to hide it on the BOE balance sheet. This was interesting as it shows how far central bankers could go in an extreme scenario (not sure ECB would lend a couple of trillion to Draghi though!). I wanted to find evidence to back this story up, and I did manage to find evidence that the BOE assets under other securities did increase in Aug 1914 by c gbp50m but couldn’t find any evidence that it was indeed a loan to the Chief Cashier (if anyone out there knows the source I would love to know if it is true!).

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