Operation "Cap that Yield !"

It seems that the announcement effect of EMU bond buying did not miss its purpose when looking at how the risk-on status of the market performed over the past 4 or 5 weeks. And it is of course not restricted to equity markets world-wide, the return numbers on various European sovereigns are very impressive indeed to say the least (cfr infra). So markets are setting hopes on reports such as Der Spiegel over the past weekend, indicating that the ECB might target a cap on yields (eg 5,5% Spain). Of course both the ECB and the Bundesbank denied these stories but like we said in a previous posting about Keyzer Söze, keeping the myth alive is a useful tool to scare the shorters. So far the ECB has not intervened yet in the market with the Securities Market Program still constant at 211 bio EUR, this since last year September/October (see http://www.ecb.int/mopo/implement/omo/html/index.en.html).

But there were already indications that various big parties started shifting strategy early August when Bloomberg reported that virtually all macro hedge funds were positioned in the wrong direction, both on the equity and fixed income front in terms of (regional) asset allocation. So they swiftly closed their shorts enforcing the movement. Another market element coming into play is of course size and importance in terms of weight in the index. For example, Italy accounts for 25% in the JPM Morgan EMU government bond index so being heavily short in this country automatically implies a severe market underperformance when maintained for too long. The rally since 24/07 (day Spanish yields spiked at all time EMU high) in some cases has been tremendous. Looking at the numbers, we get the following bond return results since the start of 2012 :

Two quotes receive some attention according to me. One London based fixed income strategist claims that the idea of a yield or bund-spread cap is a very powerful one that is likely to dominate markets in an otherwise data deprived session ; a yield limit reduces the fear for unlimited losses that drove investors out of peripheral markets and could be an incentive for investors to return. May be so, but I would suggest that in that case you do not put a number on the cap targets, otherwise you get the same problems the Swiss are having right now in handling their euro cross exchange rate target. If you play like Keyzer Söze, than go for the full monty in keeping the myth alive. And of course the Bundesbank immediately reacted with the following statement : “Government bond purchases by the Eurosystem are to be seen critically. The new program could be unlimited and decisions about potentially far greater sharing of solvency risks should be taken by governments, not by central banks". The key words here are "unlimited" and the identity of "solvency sharing". Undoubtedly to be continued in the coming weeks. Next hurdle will be end September when the Karlsruhe Supreme Court will meet again.