Tuesday, 21 August 2012

Out of the fire, back to the safety of the frying pan...


Since Mario Draghi's famous announcement that the European Central Bank (ECB) will do whatever it takes to ensure the survival of the euro, events have been moving apace.

Even long-time eurozone sceptics must accept that a huge policy shift is underway and that Europe is making an uncharacteristic rendezvous with economic pragmatism.

As an update: primary market bond purchases by the European Stability Mechanism (ESM) are to be supported by secondary market purchases by the ECB. The significance of the latter dwarfs the former. The ESM and its predecessors have never been more than one crisis away from insolvency (indeed a full bailout for Spain seems set to drain the ESM once more). The ECB's pockets, on the other hand, could potentially be bottomless like those of the UK's Bank of England or US's Federal Reserve.

Furthermore, if bond market participants believe there is a functioning secondary market they will be happy to participate in the primary market making ESM primary market purchases irrelevant.

It is already assumed that any ECB purchases would require a memorandum of understanding a promise committing to competitiveness reforms.  Most fascinatingly Der Spiegel reports unnamed sources saying that the ECB is considering yield targets for its secondary market purchases (unfortunately not available on the English language site). Yesterday evening the Telegraph confirmed these reports with a little more colour. When a body with unlimited buying potential announces a yield target that prophecy becomes self-fulfilling. Very few participants would be sellers at a yield of 6.4% if the ECB is a buyer at 6.5%. Likewise who would not be a buyer at 6.7% yield on the same basis?

The prospect of direct recapitalisation of the banking system by the eurozone's institutions was discussed at the end of June and recent pronouncements on the new secondary market bond purchase program promise to address the issue of seniority.

These developments are extremely encouraging in terms of reducing the risk of crisis in the eurozone as they address every point on the eurozone policy wish-list.

As mentioned, the suggestion of yield targets is unsubstantiated by the ECB and there still seems to be extreme reluctance amongst Germany and Finland to take the necessary steps regarding recanting seniority.  Furthermore it should be remembered that they fall well short of addressing the long-standing issue of weak European growth. Greater competitiveness may one day make EU growth into a super sized version of modern-day Germany but there are huge potential hurdles to such an outcome. Nevertheless if these policies are confirmed the step back from crisis will be a very positive move.

Guy Foster
Head of Portfolio Strategy

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