Is ECB president Mario Draghi playing with fire?
It's not clear whether Germany will back any large-scale bond purchasing programme conducted by the European Central Bank (ECB), while economists are sharply divided on the efficacy of a yield- or spread-targeting plan.
Last Thursday, ECB president Mario Draghi injected a shot of optimism to global markets, stating that he would do “whatever it takes” to save the euro. Many have taken this as a sign that a bond purchasing programme is in order, with the European Financial Stability Facility (EFSF), or the European Stability Mechanism (ESM), purchasing bonds in the primary market and the ECB buying in the secondary market. So, is sovereign debt monetisation on the cards? Many market players aren’t convinced.
“I’ve been re-watching the video of Draghi’s announcement, and it’s not clear that he’s referring to bond purchases,” says James Nixon, chief European economist at Société Générale. “The way I see it, this is a wily exercise to try and put two-way risk back in to the market and show that the ECB is still a player.” A note put out by JPMorgan’s chief European economist David Mackie outlined 12 possible tools that the ECB could use to try and control the situation, so Draghi’s response may not necessarily be a bond purchase plan. In order of likeliness these ranged from the aforementioned EFSF/ESM purchases in primary and secondary markets – so this course of action is by no means considered unlikely – to giving the ESM a banking licence.
Bloomberg has reported that Draghi is to meet with Bundesbank President Jens Weidmann to try and overcome resistance to a bond purchasing programme, with central bank insiders confirming that Draghi is trying to persuade ECB policy makers to back the plan. But this would need some form of backing from Germany, either political backing from Berlin or from the Bundesbank. At this point, the former is seen as more forthcoming, economists have told Euromoney.
There is concern about the negative market impact if Draghi fails to flesh out a plan by Thursday. "I am left to conclude that not all the pieces are on the table. It could be that he is buying time until a deal is hammered out, but people have interpreted his words very literally," SocGen's Nixon said. One stumbling block is that any ratification of the ECB's move - since it sits awkwardly with the prohibition of debt monetisiation as laid out in European treaties - might require legislative approval in Germany and parliament is in summer recess.
Of course, it’s entirely possible that Draghi is playing a slightly subtler game. After all, if he promises a bond purchasing programme, then the ensuing market confidence could entirely eliminate the need for any such purchases. “This is verbal intervention. The ECB is promising to intervene, so that then it won’t actually have to intervene,” says Holger Schmieding, chief economist at Berenberg Bank in London. “I expect that we will get more of this on Thursday: the ECB will tell us that the transmission mechanism in the periphery is impaired, and that they will need to act.”
The natural extension of this verbal intervention would be explicit yield – or spread – targeting for peripheral sovereigns. If the ECB promises that 10-year yields won’t peak above 6%, then investors would be able to buy such bonds with impunity, knowing that yields won’t skyrocket and push the sovereign into funding problems. Recent research by Nomura and BCA has endorsed such a view. But others disagree.
“I thought that we were already clear that ECB intervention needed to be limited to solvent countries. Yield targeting would be suicide. Any limit that they set will be tested and pushed,” says SocGen’s Nixon.
Of course, if the ECB takes this step then there is no turning back. The ECB's move would represent a monumental commitment, especially if markets repeatedly tested its publicy-stated threshold while potentially highlighting the monetary authority's balance-sheet constraints.
But if the ECB tried to turn its back on yield targeting, then the consequences could be dire indeed.