In the teeth of Bundesbank resistance, the European Central Bank (ECB) set out its bond-buying plan this Thursday, balancing the need to stabilize sovereign debt markets while seeking to promote fiscal and structural reforms.
Analysts are speculating how this balance will be achieved amid fears the ECB’s independence rests on a knife-edge, while the risks of damaging U-turns on sovereign debt purchases and market distortions loom large.
Amid high expectations – including a possible 25-basis-point reduction in all of the key policy rates – the consensus is that a bond-purchasing plan of sorts will be announced. However, Morgan Stanley – hot on the heels of its bearish house-view on the ratification of the European Stability Mechanism (ESM) – is more sceptical than most.
In an August 31 report, it said: “The meeting is unlikely to result in tangible actions or announcements on its new bond-buying programme. Instead, eurosystem staffers, governing council members and euroland governments will likely need more time to hammer out a viable policy solution.”
European Financial Stability Facility (EFSF)/ESM approval of a formal sovereign financing request would enhance the “democratic legitimacy of the ECB’s bond-buying programme,” Morgan Stanley argued.
Whenever a bond-purchasing plan materializes, the jury is out on three issues: how the ECB can enforce conditionality in practice and exit accordingly; how to estimate convertibility risk premia, which the programme is intended to address; and whether there should be a publicly-articulated formal ceiling announced on yields or spreads, which Euromoney has covered extensively.
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| ECB President Draghi |
On the first issue, while analysts dismiss the notion of spread-targeting, the hope is that the ECB’s support for specific individual sovereign bond markets will be seen as a backstop bid for bonds issued by the ESM. This would boost the security of ESM funding, after legislative hurdles prevented it from receiving a banking licence. However, it’s unclear how the ECB can engineer an exit without triggering market dislocation, while staying the course could also fan the flames of market distress and fuel fiscal complacency – a key German concern, says Julian Callow, chief European economist at Barclays Capital.
While a nod from politicians via the EFSF/ESM will trigger ECB bond-purchasing, exiting this programme will be far more difficult, given the political hurdles in establishing whether conditionality has been breached and, if so, the appropriate redress.
In the event, analysts reckon the ECB will allow targeted yields to rise, or, as analysts at JPMorgan put it: “We have suggested the ECB will implement a soft cap on front-end yields where it is intervening, ie. no explicit numerical statement of a target, but purchases which establish a range wherein ECB resistance to higher yields becomes progressively stronger. Where MoU [memorandum of understanding] compliance comes into doubt, the ECB could allow this range to begin to rise, increasing the pressure on the sovereign for corrective action.”
The ECB could also fuel debt-rollover fears – to prompt immediate fiscal corrections – by restricting the maturity of interventions to T-bills only, reckon the analysts.
Callow at Barclays Capital believes the ECB would pressure sovereigns, principally Spain and Italy, to undertake International Monetary Fund (IMF) supervision but the political hurdles are enormous. “The issue of exiting is a major weakness in the ECB’s approach and formal IMF involvement might yet be needed,” says Callow.
Convertibility risk
On the second issue, though the ECB is likely to opt for purchases across the board at first, analysts at JPMorgan expect ECB purchases of two- to three-year Portuguese bonds will be carried out after the September 6 meeting but the desired levels will be determined by the ECB’s internal fair-value model.
ECB president Mario Draghi, when asked, admitted at the end-July press conference that there was no agreed benchmark to determine convertibility risk. After all, the Greek sovereign debt restructuring saga showed that official sector creditors will fight tooth and nail – including retroactive legal provisions – to enforce debt restructuring without triggering a formal credit event.
Meanwhile, the market for inflation-indexed bonds or breakevens – if a country were to exit the eurozone, its inflation rate should be higher – is too illiquid.
Based on fiscal fundamentals, Callow reckons the ECB will consider a 200-300bp spread cap for two-year maturities, with spreads currently touching this upper-range after Draghi’s commitment to “do whatever it takes” to preserve the eurozone engineered a rally, biased towards the short-end of sovereign debt markets.
JPMorgan reckons that convertibility risk as a percentage of par value is highest in Portugal at 5.2% on the June 2014 note but cautioned: “There is as much art as science in an attempt to decompose yields, and small differences in assumptions can generate some substantial differences in conclusions."
It reckons that yield limit of up to 3.5% for three-year maturities will be seen as the most politically palatable target. “That [spread level] would still allow circa 300bp of room wherein markets can express views about the potential for default, where the policy rate is expected to average near zero," it stated. "In terms of the fall in the level of yields from current levels, it would mark a significant step forward in terms of monetary transmission.”
While a case can be made for uniform soft caps of 2.5%, "our sense remains that the ECB will not go this far, reflecting both the ambiguity of any calculations one may make on the extent of such premia, and a sense of a need to make political-economy-type compromises to sustain a majority on the Governing Council”.
If the ECB successfully provides an implicit backstop and sovereigns are able to refinance at a maximum 3.5% short-term rate – not too far above medium- to long-term nominal growth projections for the region – debt-sustainability fears might ease if an across-the-board market rally offsets short-term refinancing risks.
However, there are a huge number of hurdles before this bullish chain of events can materialize – not least signs that distressed sovereigns are sticking with consolidation plans; and markets are satisfied with the ECB’s commitment to intervene and deal with official sector seniority fears.
Source: JPMorgan