Thursday, August 30, 2012

Expectations ECB will bond buying plan

Expectations ECB will bond-buying plan : News that Mario Draghi has pulled out of the Jackson Hole symposium has stoked expectations that the that European Central Bank president will unveil details of the bank’s revamped bond buying programme after next week’s governing council vote.

Much uncertainty surrounds the details of the programme ahead of Thursday’s decision. Here’s a guide to some of the details that markets – and some eurozone sovereigns – will look for Mr Draghi to announce at the post-meeting press conference.

Countering convertibility risk

At the end of July, the ECB president vowed to do “whatever it takes” to counter the “convertibility risk” associated with a break-up of the eurozone, which Mr Draghi claimed was priced into the debt of some eurozone sovereigns.

It is unclear how large Mr Draghi and other members of the governing council think these convertibility premia are. The International Monetary Fund thinks Spanish and Italian 10-year yields were about 2 percentage points higher than justified by economic fundamentals in the first half of this year. But in his August presser, Mr Draghi refused to be drawn on this matter.

Word is that there has been some disagreement between members of the governing council over how to measure convertibility risk.

Explicit cap on yields?

Der Spiegel recently reported that the ECB will consider capping the spreads between German bond yields and those of other government debt as part of the new bond-buying programme.

The central bank did not flat-out deny that it was considering this option, saying only that it was “absolutely misleading to report on decisions which have not yet been taken, and also on individual views, which have not yet been discussed by the ECB’s governing council.”

But, while it is difficult to see how the programme can operate without the ECB having some idea of the level of yields that it would tolerate, there are a few reasons to think that explicit caps on the spread between German and peripheral debt is an unlikely option. The most compelling of these is that an explicit cap on spreads would, in effect, remove the conditionality that the ECB president wants linked to further bond purchases.

Mr Draghi made clear earlier this month that the ECB would not act without “strict and effective conditionality” from sovereigns, ie governments agreeing to meet commitments on fiscal consolidation and structural reform. But if the central bank were to announce an explicit cap, then there would be little to stop governments reneging on these commitments.

An explicit cap is also likely to result in other members of the governing council joining Jens Weidmann, Bundesbank president, in opposition to the plan. Mr Weidmann said over the weekend he believed he is not the only member of the ECB’s governing council to have “stomach pains” over the issue of bond purchases. The more hawkish members of the governing council, such as the heads of the Dutch and Finnish central banks, would probably feel a little queasy about an explicit cap too.


The ECB is thought unlikely to push for sovereigns such as Spain and Italy to sign up to any commitments that are stronger than those already agreed between member states and the European Union.

But members of the governing council are concerned about how the ECB would react if a country were to miss targets set by Brussels. If bond purchases were stopped at the same time as a country missed a target for its budget deficit, then that’s the sort of double blow that could cause bond yields to soar. Does that then mean that the ECB might be forced to continue purchases regardless of whether or not sovereigns backtrack on their commitments?

What to buy

Mr Draghi signalled that the ECB’s bond buying efforts “will be focused on the shorter part of the yield curve”. We should find out next Thursday how short.

The argument for buying at the short end is that this will act as a disciplining mechanism on misbehaving sovereigns. If a sovereign’s economic policy is credible, then a decline in yields in short-term debt will be matched with declines further out on the curve. However, if a sovereign backtracks on its commitments, then it will be forced to roll over its debt at ever shorter maturities, leaving it at the mercy of the ECB.

Addressing concerns over seniority

Mr Draghi said at the start of August that concerns among private investors about the seniority of the ECB over other bondholders “will be addressed”.

Markets welcomed the news. The ECB, thought to have bought Greek debt with a face value of €50bn, sought special treatment when the debt was restructured. Bond market fears that the ECB would again get favourable treatment at their expense in the event of another sovereign default was considered a major stumbling block to the success of further bond purchases.

But it’s not clear exactly how these concerns will be address. Or whether it will apply to the ECB’s existing stock of government debt.

Mopping up

So far, the ECB has mopped up the excess liquidity created by its bond purchases by offering banks the chance to park an amount of funds equal to the size of its purchases in the central bank’s coffers. In return, banks are paid interest on these deposits.

The ECB has used this technique, known as “sterilisation”, to distinguish its debt purchases from quantitative easing as carried out by other central banks, such as the Federal Reserve and the Bank of England, and allay concerns that its bond buying will trigger inflation. But Mr Draghi earlier this month raised the possibility that future bond purchases will not be sterilised:

“You should not assume that we are not going to sterilise or that we will sterilise – you have to understand, these operations arwe complex and they affect markets in a variety of ways.”

In one sense this is not terribly significant; either way there is plenty of excess liquidity sloshing around the Eurosystem. But the Bundesbank probably wouldn’t like it if the bond purchases weren’t sterilised.

A far bigger issue is whether the governing council will be able to agree on the detail ahead of the 6 September meeting. Bloomberg reported last week that the ECB could wait until after Germany’s constitutional court rules on the legality of the European Stability Mechanism, the eurozone’s permanent bailout fund, to unveil details of the scheme. The court won’t rule until September 12.

Governing council members expect an agreement on the details in time for next Thursday’s post-meeting presser. However, according to people familiar with the situation, there are increasing doubts about whether this will be possible. Which perhaps explains the reluctance of Mr Draghi and his fellow executive board members to make the trip to Jackson Hole.

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