About that nuclear option: ECB yield- or spread-targeting


Euromoney Skew, Sid Verma
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Analysts believe a formal yield or spread target in the European Central Bank's (ECB) sovereign bond-buying plan is unlikely for now, despite elevated market expectations.

In the house of intrigue that is the eurozone, there is still a slew of unanswered questions about the ECB’s bond-buying plan.

What we know:

- ECB officials are said to be waiting until September 12 when the German constitutional court rules on the legality of the European Stability Mechanism (ESM).
- It’s not clear if ECB action will precede a sovereign bailout request.
- Any Spanish funding request made to the European Financial Stability Facility (EFSF) would also presumably activate ECB bond-buying, which would help to cap yields in the secondary market.

During the past few weeks, there have been rival briefings from ECB, Bundesbank and Spanish officials about the efficacy and timing of the ECB’s much-hoped monetary aggression.

Of particular cause for cheer or fear is the vexed issue of spread- or yield-targeting by the ECB. There are concerns that any  intervention by the single currency's monetary authority in Spain will prove short-lived, given the macro-economic and market dysfunction, and markets could well see it as an opportunity to sell.

By contrast, a publicly announced yield or spread target could prove powerful. After all, ECB president Mario Draghi’s words alone in late July – promising to “do whatever it takes” to protect the euro – managed to engineer a euro rally, a sell-off in the bund market and spread-tightening, to a modest extent, in the peripheral eurozone sovereign debt markets. News that Draghi is likely to miss the Jackson Hole summit has fed speculation he is working on a big plan for the eurozone. 

Euromoney first investigated the issue of targets in June. This followed a Nomura report on the controversial step of advancing yield- and spread-targeting as the solutions to the eurozone's woes:

The most effective form of QE would be if the ECB targeted yield levels. We believe this could most swiftly transform the asymmetry of risk that market participants currently face. For instance, the ECB could say that 10-year SPG yields would not rise above 4.50% for the next two years at least. After the ECB‟s resolve has been tested through a period of aggressive buying at this level, were yields to be trading at 4.45%, investors might believe they faced 5 basis point downside rather than PSI risk. In this respect, yield targeting would likely involve less market intervention than a more traditional QE.

Still, Nomura reckoned spread-targeting would be more palatable to ECB officials:

Spread-targeting would be similar to yield-targeting, albeit with one potential drawback: to be effective, yield-targeting would involve setting yields at levels that are consistent with a sovereign's solvency; spread-targeting cannot guarantee that a level would be reached if, for instance, bunds sell off meaningfully. However, give the strength of structural demand for bunds, this is a not a risk that would unduly concern us.

In addition, it is worth noting the risk that the ECB imitates yield-targeting for selected non-core countries but remains guided by moral hazard and sets its buying level at rates at or above current levels. Unless yields are capped at levels that make a country solvent, then the ECB‟s purchases would – like the SMP – merely be used as an exit strategy for investors.

Any ECB bond-buying plan in unlimited size would need massive resources, and failure to make good on its promise could roil markets. For these reasons, many analysts reckon a public target is unlikely. In July, James Nixon, chief European economist at Société Générale told us: "Yield-targeting would be suicide. Any limit they set will be tested and pushed.”

Megan Greene, economist at Roubini Global Economics, is also bearish. Writing in her blog last week, she said:

Even if the ECB were willing to intervene in an unlimited fashion, conditionality and yield/spread caps are fundamentally incompatible. The ECB has been adamant it will only purchase the bonds of those countries that have already signed up to the conditionality attached to EFSF/ESM support. If the ECB precommits to a specific yield or spread target, what happens when that country fails to meet the terms of its conditionality? If the ECB were to give up the yield/spread target, then it would lose credibility, and investors would rush to bet against the cap. If it didn’t abandon the target, then countries receiving ECB support would no longer be incentivized to undergo the painful adjustments being demanded of them. Germany and other core countries would likely find the resultant moral hazard unacceptable.

Finally, an announced yield target would severely reduce the ECB’s flexibility in terms of deciding when and how much it plans to intervene. The ECB’s independence would be seriously compromised as a result, an issue with which various members of the governing council might take umbrage.

Given the self-interest the ECB has to preserve the value of its collateral on its balance sheet, the fact that rising short-term peripheral sovereign bond yields could trigger money-market stress despite systemic liquidity  – impeding the transmission of monetary policy – and the need for the market to shrug off Spanish or Italian debt restructuring risk, market pressure for the ECB to embark on the nuclear option is likely to remain.

Granted, most analysts believed earlier this year that short-term yields on Italian sovereign debt needed to rise before the ECB even considered LTRO3, let alone full-scale quantitative easing with a yield target. And market pressures on Italian debt have eased some what, given the capacity of Italian banks to soak up debt supply and a relatively calm debt-issuance calendar.

However, the danger is that market expectations for the ECB's meeting on September 6 are too high, inspiring an all-too familiar sell-off if there are signs a bond-buying plan is too timid.