Monday, August 20, 2012

The ECB to potentially target periphery yields via unlimited buying

Today Der Spiegel published an article called "Aiming the Bazooka: ECB Plans to Set Yield Targets for Bond Purchases" discussing what could become the ultimate backstop for periphery government bonds.
Der Spiegel: - As part of its efforts to fight the euro crisis, the European Central Bank (ECB) is considering establishing caps on interest rates for government bonds in individual countries as part of its future bond-buying program. Under the plan, the ECB would begin purchasing government bonds from crisis-hit countries if yields for those bonds exceeded the interest rates for benchmark German sovereign bonds by a predetermined amount. This would signal to investors which interest rate levels the ECB believes to be appropriate.
Targeting yields rather than specific amounts of bonds to purchase is not a new idea. In fact it has been considered by the Fed as an alternative version of QE3. But with respect to periphery debt, this would indeed be a "bazooka". The ECB would be providing a free put option to holders of sovereign debt and would even give more transparency on its bond purchases.
Der Spiegel: - During its next meeting at the beginning of September, the ECB's Governing Council is expected to decide on whether the interest-rate goal will actually be implemented. However, it has already been decided that the ECB will be more transparent in the future about its bond purchases. Looking ahead, the ECB plans to publicly state the volume of bonds it has purchased from each country. This information is to be published immediately after the purchase takes place. Under current practice, the ECB announces on Mondays how much, in total, it spent on buying bonds the previous week.
As is often the case in these situations, Der Spiegel is not disclosing its sources and it's unclear how the newspaper obtained this information. But the way some official information has been leaking out of the Eurozone in the past, it is quite possible that this article is indeed accurate. It is certainly true that the Spanish officials have been calling for unlimited bond purchases to stabilize yields for some time.
Bloomberg: - Spanish Economy Minister Luis de Guindos urged unlimited bond buying by the European Central Bank to lower the struggling euro country’s borrowing costs as talks on conditions for the aid are planned in September.

ECB bond buying on the secondary market should be unlimited in duration and size to support the nation’s debt, De Guindos told Spanish news agency Efe in an interview. Terms for the assistance will be discussed at a euro group meeting in the second week of September, he said. The comments were confirmed by a Spanish official, who asked not be identified, citing government policy.
The markets are viewing this story as having a real chance to become reality. Since the rumors of this unlimited bond buying program got started, Spanish bond yields came off sharply.

Spain 10y yield

It is somewhat surprising that German officials have not been more vocal in their objections to such proposals. The size of the purchases could be enormous, with the ECB potentially becoming the proud owner of a substantial portion of Spain's outstanding debt. The ECB's holdings would of course be senior to the private holders (remember the subordination issue?). Also the purchases would likely be done via the Bank of Spain, further increasing TARGET2 imbalances and making Spain's potential exit ever more costly. But so far it has mostly been just the Bundesbank pushing back on what they view as a perversion of a central bank's function.
Bloomberg/BW: - Germany’s Bundesbank stepped up its criticism of the European Central Bank’s plan to embark on potentially “unlimited” government bond purchases, widening a rift over how to tackle the sovereign debt crisis.

“The Bundesbank holds to the opinion that government bond purchases by the Eurosystem are to be seen critically and entail significant stability risks,” the Frankfurt-based central bank said in its monthly report today. The new program “could be unlimited” and decisions about potentially far greater sharing of solvency risks should be taken by governments or parliaments, not by central banks, it said.
The biggest problem with such yield targeting is the establishment of moral hazard by reducing the impact of market discipline. Knowing that the central bank will support their nation's bonds in an unlimited fashion, periphery politicians will no longer be under pressure to implement austerity measures in a timely manner. The fiscal consolidation work will be put on a southern European timeline and the can will be kicked further down the road.
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