Wednesday, January 12, 2011

Do they finally get it?

The much feared Portuguese auction went well earlier today with the Treasury being able to place EUR1.25bn of 4y and 10y bonds, the high end of the intended 0.75bn-1.25bn range. The main reason for this outcome should be seen in the significant buying of peripheral bonds by the ECB earlier this week. This put the dealer community short in peripheral debt including Portugal and thereby provided much support for today's auction. Furthermore, it saw peripheral bond spreads tighten sharply over the past days. This shows that ECB bond buying can have a significant impact on market dynamics. If the ECB effectively provides a cap on peripheral bond yields, then it can a) also draw back private investors into the market again as it reduces near-term potential mark-to-market losses whereas the carry available through the high bond spreads renders investments attractive again, b) change the underlying debt dynamics of the peripheral countries (c.p. lower yields mean that deficits are being reduced) and c) lead to a less restrictive monetary environment for the countries in question which supports growth. Additionally, each of these effects is reinforcing each other and therefore significant ECB buying has the potential to establish a positive feedback loop (Establishing such a positive feedback loop via a significant bond buying programme is what I suggested the ECB should do in Monetary easing in the wrong places or will the real ECB please stand up dated November 17). This would just be the opposite of the dynamic which has been at work so far where higher yields work to worsen deficits, reduce growth and deter investors, resulting in higher yields again.
Furthermore, proposals to increase the size of the EFSF and to broaden its mandate which would include buying of government bonds in the secondary market have been doing the rounds. This could even result in an improvement over a bond-buying programme by the ECB as it prevents the ECB from becoming too much involved in political issues. Furthermore, it would allow the ECB to continue concentrating on its main policy instruments (the setting of the short-term repo rate and the provision of liquidity).

Bolder ECB action causes significant yield drop in peripheral bonds (10y benchmarks)

Source: Bloomberg

I am convinced that bold and sustained action by the ECB (or potentially the EFSF) can establish a positive feedback loop which would result in a fundamental change in the dynamic of Eurozone government bond markets. It would go hand in hand with an aggressive and lasting tightening of peripheral government bond spreads as well as the pricing of an upcoming rate hike cycle into the Bund curve. So far, it is too early to tell and we would need to see follow-through action by the ECB. My guess is that an increase in the size of the EFSF and a broadening in its mandate could come together with a bail-out of Portugal. First, the actual size of the EFSF would not be enough to provide a bail-out for Spain - the domino behind Portugal - and therefore the urgency for change is intensifying even further at that stage. Second, I think that it would need a concrete event (the bail-out of Portugal) for such a decision to be taken to appease the public in the core countries. Economically it would make more sense to go down that route already now (i.e. somewhat preemptively) but politically it might be harder to do.
Overall, I remain of the opinion that Ireland, Portugal and Spain have the ability to solve their combined over-indebtedness and uncompetitiveness issues over a time horizon of 3-5 years (Greece will have more problems to do so). Establishing a positive feedback loop via a massive bond-buying programme would go a long way towards providing these countries with the necessary time. I have argued already in May last year (Wirtschaftswunder 2.0 - longer-lasting high growth period ahead for Germany) that re-establishing corporate competitiveness will occur not only via sustained lower growth & inflation in the periphery but also via higher growth & inflation in the core countries, especially Germany. Furthermore, as the Eurozone balances again internally, its external current account balance will move from being around zero to a significant surplus. I see no reason yet why I should deviate from this scenario which compared to most commentators constitutes a positive outlook.


  1. hi daniel

    what's your take on Trichet's performance yesterday?

  2. I hope to write more on this over the next days. In short: The ECB has tried to remove the exceptional liquidty support measures twice and both times it backfired. Going forward I think they will be more careful in removing these measures again. The question of rate setting is a completely different one and I expect them to hike rates soon after a more lasting solution for the EFSF has been found. For example, should it be decided to increase the size of the EFSF and to broaden its mandate so that it can start to buy bonds in the secondary market, then expect the ECB to start its hiking cycle around May/June.

  3. Technically, a judge sets bail, which is the term for any required payment to get out of jail pending trial. In essentially the same breath, the judge then allows bail to be posted via a bond.