The new ECB takes shape II

Summing up: the ECB is now also the lender of last resort for the sovereigns. As with banks (solvent banks are kept liquid), the ECB now also will keep solvent sovereigns liquid. The EFSF/ESM will take care that the sovereigns remain solvent. It does not matter whether they buy only up to 3y or longer. That is not that important in the grand scheme of things.

(This is a follow up to "The new ECB takes shape" dated August 7)

The ECB has delivered a massive step. Up until now, the mandate of the ECB was to deliver price stability for the Euro area and to be the lender of last resort for the banking sector. The latter function meant that the ECB did everything to keep solvent banks liquid. However, the same was not the case for sovereigns. Now, also solvent sovereigns will be kept liquid. The conditionality that sovereigns have to apply for help from the EFSF and ESM should ensure that he sovereigns are solvent. The result, is that the solvent sovereigns cannot become illiquid. This was a key risk for the peripheral markets amid the threat of a buyers’ strike developing. The combination of lower short end yields (which will translate into lower average interest costs for new debt) and a much reduced risk of illiquidity significantly reduces the risk of investing into long-term peripheral bonds as well. Additionally, the expectations that the ECB will be announcing a programme to buy short-term bonds has led peripheral curves to much steeper levels. However, such a steeper curve with a very high likelihood that short-term yields stay low for a protracted period of time, means that horizon returns (i.e. returns under the assumption that the yield curve stays unchanged) increase whereas investment risk falls. The result is that investing into securities which are longer than the ECB’s stated maximum maturity of 3 years has become much more attractive. While some risks remain (ESM verdict by the German constitutional court, timing of applying for help by peripheral countries etc.), I favour the 4-7y area of the Spanish and Italian curves at present given the steepness of the curve and expectations for a reduction in volatility.
Overall, as the ECB now keeps solvent banks liquid and solvent sovereigns liquid, the systemic risks of a meltdown in financial markets amid a domino bankruptcy in banks and sovereigns has been much reduced. The combination of a 0% deposit rate with a high amount of excess liquidity should increasingly force investors to search for yield via extending on the yield curve and moving out the rating spectre. Hence the longer-term trend towards lower nominal yields on carry products is far from over. The recovery in the Euro which has taken shape over the past weeks can run further as investor positions remain tilted to short side.