Nomura's audacity of hope - about the ECB's monetary aggression - springs eternal. The well-known context: the eurozone's leaders' default policy response of pro-cyclical financial and fiscal tightening isn't cutting it, and is having the disastrous effect of forcing the eurozone's most fragile members into increasingly damaging recessions. In short, the eurozone crisis has hit its endgame, the bank reckons.
While Greece is, as always, worrying, the focus now seems to be on Spain. The country is dangerously close to losing market access - yields on 10-year debt are showing an annoying habit of hitting new euro-era heights. With Nomura estimating a 3-year bailout package as clocking in at €550 million, rescue via the ESM isn't looking attractive, to say the least. With German refusing to embark on fiscal transfers, Nomura says it's high time for monetary policy to do the hard work.
The bank is taking the controversial step of advancing yield and spread-targeting as the solutions to the eurozone's woes.
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The most effective form of QE would be if the ECB targeted yield levels. We believe this could most swiftly transform the asymmetry of risk that market participants currently face. For instance, the ECB could say that 10yr SPG yields would not rise above 4.50% for the next two years at least. After the ECB‟s resolve has been tested through a period of aggressive buying at this level, were yields to be trading at 4.45%, investors might believe that they faced 5bp downside rather than PSI risk. In this respect, yield targeting would likely involve less market intervention than a more traditional QE.
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Have no fear, Nomura is not living in a complete fantasy land. While it thinks yield-targeting could have some very beneficial effects for the eurozone, it's quite clear that it does not envisage the ECB going quite that far. Instead, the bank puts forward the idea of spread-targeting - citing reported pressure from Italian officials.
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Spread targeting would be be similar to yield targeting, albeit with one potential drawback: to be effective, yield targeting would involve setting yields at levels that are consistent with a sovereign's solvency; spread targeting cannot guarantee that a level would be reached if, for instance, Bunds sell off meaningfully. However, give the strength of structural demand for Bunds, this is a not a risk that would unduly concern us! In addition, it is worth noting the risk that the ECB imitates yield targeting for selected non-core countries but remains guided by moral hazard and sets its buying level at rates at or above current levels. Unless yields are capped at levels that make a country solvent, then the ECB‟s purchases would – like the SMP – merely be used as an exit strategy for investors.
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Of course, this proposal is going take a big commitment from the ECB. For one, spread-targeting would require:
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Unbounded size. To be effective, the ECB would need to have the capacity for unbounded intervention for a period of time, or at the very least allocate a significantly large pool of resources to the program. If not, the market may not view the spread target as inviolate and hence may use it to exit positions at good levels.
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Forgive the comic understatement, but this could prove to be a hard sell to the ECB. Especially with the new, more direct role that Nomura is envisaging:
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The ECB, rather than being a conduit, needs to be the bond purchase mechanism ... The ESM as an institution still has direct fiscal linkages to sovereigns via paid-in capital and callable capital. While the ECB could, for instance, finance an increase in paid-in capital which could be leveraged via the ESM, the loss-absorbing capacity of the institution continues to migrate to sovereigns. In contrast, the ECB could have a capital deficit without the legal need to be recapitalised. The ECB is the only entity that can effectively execute a large-scale QE program – the ESM cannot (just today, the German Constitutional Court has announced that the German government did not sufficiently inform parliament about the configuration of the ESM).
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This might sounds like heresy for the Bundesbank but markets might yet sing from this hymn sheet if, as is likely, the 28-29th June summit proves to be yet- another flop.