A primer on ECB September 6 : "High time for a comprehensive approach"
That were Mario Draghi's concluding remarks speaking before European Parliament in Brussels earlier this week. Again by times a clever effort following his Zeit open letter last week where some more psychological pressure was put onto the German people. Let's see what his main message was in order to know what we can expect next Thursday :
1) "By buying up bonds, do we give up our primary mandate for maintaining price stability? It’s exactly the opposite situation...We cannot pursue price stability now with a fragmented euro area because changes in interest rates affect only one country, or two countries at most. They have no importance whatsoever in the rest of the euro area. ECB bond purchases are therefore a way to comply with our primary mandate: Frankly, all this also has to do very much with the continuing existence of the euro."
True as this might be, there is currently only 1 problem with this : Mr Market has lost confidence in this convergence and no longer has any form of trust in certain bonds, meaning in the project as a whole. So looking right now at the market - right or wrong - the single currency no longer covers all the nations that carry the currency. And so Mario Draghi comes to his second point, linked to this :
2) “Markets have perceptions of a certain country in a crisis. Therefore they ask for higher interest rates in order to buy the bonds issued by the country. And when I say bonds I don’t only mean government bonds. Bank bonds, corporate bonds. Markets are asking for higher and higher interest rates, which in return reinforce the situation of the perception of the crisis. That’s where the main justification to step in is for the ECB and start buying bonds.”
This is a tougher one because I think he touches here a delicate point. When the going gets tough, it only becomes tougher when Mr Market gets his way. And that's why rating agencies can be very dangerous firestarters, in many cases like the firebrigade firefighting fire with kerosine. For me Draghi's rationale contains "fairness" when looked upon in a global framework : Why should Italy for example fund itself at 6 or 7% when its fundamentals are comparable - in some cases even better - to the US, UK and others who enjoy the market's confidence in between 0 and 2% ? Public debt : comparable. Primary budget : surplus, better than most EMU countries by the way and better than the UK and US. Housing bubble boom and bust? No, sir. Domestic savings surplus ? Yes. Structural market and growth problems, yes, but that cannot in itself justify the current rate spread. But others will claim that the UK and US situation is different because they have their own currency dito reserve status and can print their way out any time, supported by politics. Come again ? So the justification would be that Mr (free) Market awards money printers. Seems a little bit strange to me to say the least. A classic consequence of all this would be that long term interest rates (inflation expectations) should shoot up etc etc. But let's have a look now at the important third part :
3) “If we are to buy long-term bonds we are in a very delicate situation. But if we go on the short-term part of the market where bonds have a length of time, a maturity of up to one year, two years or even three years, these bonds will easily expire, so there is very little monetary financing if anything at all that we are doing.”
First of all, me and my colleagues have done some research and couldn't find anything legal on this subject with respect to the ECB mandate. But the argument would be that as long as you buy up short term bonds, it isn't really monetary financing of public needs. Now this only holds of course if you limit yourself to a one-off experiment. If you repeat this 10 times, the argument becomes pretty weak of course (short term QE @ infinitum = QE). But Draghi adds the following to this : "While many countries have made “substantial progress” recently, we can’t exclude that at some point in time this progress can easily stop because of adjustment fatigue. So that’s why we are asking for conditionality combined with these interventions by the ECB. I think this could stand against the charges that we are doing monetary financing, because we are not doing it.” Briefly urging a Karlsruhe green light on 12 September, quid pro quo but on this point, I return in my concluding remarks.
Now suppose intervention on the short end (up to 3 years) takes place, will it affect the longer part of the curve ? Well, it might be that market mechanics might set this in motion : if - and only if - the idea is credible (medium term survival EMU) and in combination with a very positive slope of the yield curve, it opens up plenty of opportunities for financial players to play carry (through repo etc). And this might indeed push the long term yields of some countries into convergence drive towards Germany. But at that point, it are private sector players who accomplish this - admitted with a little help from Frankfurt - but not the ECB nor Buba.
What else did we pick up lately? Some German comments in favor of ESM (Merkel/Schauble) but at the same time moderating market expectations (everything has to be done within the possibilities of the current legal framework). Surprisingly up until now nothing mentioned on the ECB SMP program which can be invoked temporarily to relieve market strains. But it's in fact temporarily and may be they should be seeking for something more comprehensive. The menu for next Thursday's possible EMU D-Day :
1) Rate cut (25-50 bp) justified by the usual ECB speak (medium term inflation expectations in check and business cycle stance warranting it). Simultaneously an adjustment of the deposit rate to zero or may be even negative, going swissie/danish on this one. And an adjustment of the emergency lending rate (Lombard rate) with a tighter target towards the main refi rate. May be finally a commitment that should LTRO3 be necessary somewhere in the future, they will push the button : unconditional market liquidity as lender of the last resort, in line with mandate. That should stabilize market sentiment for banks and financials.
2) QE and max 3y government bonds : The fact that this has been discussed in the open and the way Draghi defended this in his speech, seems to point to the fact that core Europe, Germany included, just might accept this as the maximum limit in terms of monetary policy crossing the Rubicon. Looking at how markets have already pushed the short end of Italy/Spain over the past couple of days, it seems that they cannot afford to disappoint here : It's pretty much a done deal as far as Mr Market is concerned and considerably being priced in, day after day as we approach D-Day.
3) I think the press conference will be important with high stakes and high expectations. But in order to be credible, I believe politicians should seize the opportunity to have their own press conference as well, this shortly after the ECB's one. Herman Van Rompuy for example, flanked by European political leaders, re-iterating the conditionality approach and confirming that there is a joint European political platform for this. And that it will be institutionalized into legally binding rules with a draft proposal ready to be signed in the very short term.
Alea iacta est ? We will know next Thursday starting from 1.45 PM onwards.