Q&A: The latest ECB policy decision
Draghi has announced the ECB’s much anticipated bond buying plan today and it was more detailed than some had thought. Obviously skipping the Jackson Hole conference last weekend paid off, as the ECB seems to have developed a fully formed bond-purchasing plan. But what does it mean and what could its impact be on the euro? We have tried to answer a few questions below in attempt to understand exactly how effective the latest remedy to the sovereign debt crisis will be.
1, Does it matter that the debt purchases are unlimited if the ECB will sterilize all the bonds it plans on buying?
The ECB’s new bond-buying programme might be unlimited but one of the technical features of the programme is that it is fully sterilised. Thus, the ECB is trying to define its programme as being different to quantitative easing that has been adopted by the Federal Reserve in the US and the Bank of England. However, although the ECB plans on giving money to struggling sovereigns with one hand it will take away the extra liquidity with the other hand. This is probably net negative for Germany. Due to the negative correlation between Germany and Spain and Italy’s bond yields - its yields have risen nearly 30 basis points over the last week while Spanish yields have fallen more than 90 basis points over the past month - we would expect German bond yields to rise further, if this new action by the ECB continues to be well received by the markets.
Thus, although purchases are sterilised, you could argue that the ECB is boosting liquidity in the weaker economies, while at the same time taking liquidity out of the stronger economies. This balancing act is why the ECB can get away without having to do “outright” QE unlike the Fed or the BOE.
2, Past attempts by the ECB to help solve this crisis haven’t had long term positive impacts, will this programme fail too?
The ECB’s LTRO loan scheme announced at the end of 2011 boosted liquidity to Europe’s struggling banks to avoid a cash crunch. However, the main criticism it faced was that it allowed banks to spend that money and stock up on more toxic sovereign debt. Thus, the latest ECB plan is targeting the epicentre of the problem – the sovereigns. From a credit investors’ point of view/ market dynamics view Spain and Italy should now become more creditworthy. If Rome and Madrid agree to the conditionality that the ECB demands in return for bond purchases then investors have a reliable seller if they no longer want to hold Spanish and Italian debt. This supports further declines in Spanish and Italian bond yields in the medium-term.
From a macro perspective the ECB’s latest plan could reap benefits too. It is trying to ensure that bond purchases will only be granted if the country agrees to a strict fiscal consolidation plan that includes the involvement of the IMF. However, will Spain and Italy agree to the conditionality? That will be answered in a later question.
2, It appears that Germany dissented and didn’t agree with the Outright Monetary Transactions (OMT) programme. Does this have any long-term ramifications for the ECB and the effectiveness of ECB policy action?
The Bundesbank is the likely dissenter and after the ECB meeting it reiterated its dislike of the ECB buying sovereign debt. However, the German central bank seems to have had some of its views listened to. For example, there was no rate cut, the bonds purchased will have short durations and be fully sterilised. Likewise, the emphasis on conditionality has Germany’s name written all over it.
So although we may not have got full blown unity between Germany and other Eurozone members, it would appear that Germany can at least live with this plan. However, if markets lose confidence, or Spain and Italy don’t agree to the conditions attached to bond purchases then it is hard to see the Bundesbank allowing the ECB to do anything else to try and sort out this crisis.
3, The ECB did not cut rates – does that matter?
Not really. Real interest rates that are adjusted for inflation are already negative, so it’s hard to justify that a rate cut would benefit the Eurozone economy.
4, Is the ECB’s change in its creditor status the most important aspect of today’s decision?
I would argue yes. The Greek bailout caused large amounts of volatility in financial markets because the ECB placed itself ahead of the ordinary private investor to be paid back in the case of a default. This had negative side effects on the bond markets of Spain and Italy earlier this year.
By agreeing to be paid alongside private credit holders rather than give itself special creditor status, the ECB may boost private sector interest in Eurozone debt. Markets like fairness and transparency. As the ECB found out with Greece when investors’ believe they are being treated unfairly they head for the exits.
Now that the issue of ECB conditionality has been confirmed it could boost confidence in peripheral credit markets. In the past Spanish bond yields have had a negative correlation with risk assets. So if Spanish and Italian bond yields continue to fall we could see European stocks rally in the medium-term.
5, Draghi emphasized conditionality of bond purchases, will Spain accept this conditionality?
So far Spain has been reluctant to accept more conditions in return for financial aid. Spain has a sky high unemployment rate and its economy is extremely weak, so more fiscal austerity could be counter-productive. However, if it did accept the conditionality there is a link between falling bond yields and rising economic and consumer confidence levels, which could eventually feed through to a stronger economy. This argument could be used by Madrid to justify further bond purchases.
Added to that, Spain has a EU20 billon bond redemption due in October and also approx. EU30 billion of debt to raise later this year, which will boost its debt issuance schedule substantially. If it can’t attract enough investors to sell this debt to and the price of financing is too high then we could see Madrid forced to request an ESM/ EFSF bailout that could trigger the ECB’s OMT programme.
Likewise, Italy’s weak economy (the OECD predicts a 2.4% contraction this year) could push it to accept a bailout or a cautionary line of credit from the EFSF/ESM in the coming months, which would also give the ECB the green light to buy Italian debt.
So today’s action has reduced the “fear factor” from a Spanish or Italian bailout in the medium-term.
6, What are the long-term ramifications for financial markets?
EURUSD has ended the European session stuck at the 1.2640 level, a key resistance zone. However, the continued test of this resistance level suggests that it could be breached in the coming days. Above here opens the way to 1.2750 – the high from June, and possibly a move back to 1.2850 in the medium-term – the 200-day sma. But if there is a lot of noise from the Bundesbank in the coming days then we may see EURUSD retreat back towards 1.25 then 1.2430 – the top of the daily Ichimoku cloud. In the long-term we believe that the downward revision to the ECB’s growth forecasts could keep a lid on euro gains however, and we see it trading between 1.24- 1.30 for the rest of this year.
There is a caveat to this forecast. The German Constitutional Court needs to agree on the legality of the ESM long-term rescue fund next week. We think it will agree to it, but if it does not then expect a massacre in the euro and euro-based assets.
EURUSD daily chart
Spanish 10-year bond yields and Eurostoxx index (Spanish bond yields have a negative correlation with European stocks, as you can see in this chart).