Market commentators are still struggling to decide how much significance to attach to yesterday’s failed German government bund auction. Rates strategists at Deutsche Bank suggest it showed investor resistance only to yields driven to record lows by Germany’s safe haven status. It did not reveal serious concerns about the country’s credit fundamentals. Had yields been just a few basis points higher, bids would have been much stronger.
But even the sanguine Deutsche bank analysts sound jumpy:
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Barclays’ analysts take a more guarded view, suggesting the auction raises another red warning flag:
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Meanwhile, Gary Jenkins, head of fixed income at Evolution Securities, comes up with an intriguing read-across to possible future ECB action:
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Maybe there’s another way to look at this.
Maybe the ECB thinks its policy is working perfectly. For many central bankers on the ECB governing council, the last couple of weeks must look like an extraordinary success. Government bond yields have risen to the point where politicians finally realize the seriousness of the situation. Three new governments in Italy, Greece and Spain are making early efforts to enact measures to consolidate public finances and will hopefully follow these up with structural reforms to improve competitiveness. The ECB might be congratulating itself that its bond buying through the SMP has been just sufficient to prevent outright financial catastrophe but limited enough to avoid moral hazard. It has compelled governments to act.
But what happens next if eurozone governments take what the ECB considers to be the correct steps and yet investors continue to abandon the dysfunctional and illiquid government bond markets? Next year, governments have huge volumes of financing to do on the primary markets and may lock themselves into an inescapable debt trap if they have to complete it at very high spreads.
One answer might be for the ECB to begin quantitative easing in the name of monetary policy transmission to stave off deflation, rather than of capping government bond yields or anything else that smacks of financing governments. After all, the traditional offset for tightening fiscal policy is looser monetary policy, and ECB policy rates are low already. Moreover, the transmission mechanism through government bond markets is even more broken now than when the ECB first began buying government bonds in May 2010.
Rather than just targeting the periphery under quantitative easing, the ECB would probably have to buy across a representative sample of the eurozone government bond markets, perhaps based on its own capital key, which heavily weights Germany and France. If it was feeling a little cheekier, it might propose buying according to a European government bond index that would give greater weight to Italy. For the ECB to enact such a policy of quantitative easing, the economic outlook would have to appear grave indeed. The central bank would also no doubt require abundant political cover, including an undertaking by the council of ministers to indemnify it against losses born during the undertaking of extraordinary monetary policy measures.
The experience of the Bank of England suggests that if the policy of quantitative easing works and if it restores confidence to bond markets – even as debtor governments consolidate finances and enact structural reforms to boost growth in the longer term – then the ECB might even make a profit. Of course, those are two big ifs. Perhaps more significantly, the Bank of England experience also suggests that once a central bank establishes a policy of quantitative easing, the size of any such programme can be increased relatively easily.