Assessment of the announcement by the European Central Bank

The European Central Bank’s (ECB) new ‘Outright Monetary Transactions’ (OMT) program will enable the ECB to make unlimited, sterilised purchases of sovereign bonds in the secondary market.

This latest move is unlikely to be the magic bullet markets are looking for to resolve the crisis, however, it should help contain peripheral yields at the shorter end of the curve.

Key features

• Bond purchases will be conditional: the ECB will only buy the sovereign bonds of countries that have entered an agreement with the euro area rescue vehicles (EFSF and ESM). The aim is to keep the interest rates of Spain and Italy from spiralling.
• No yield targets will be set: the ECB have stopped short of setting yield targets, apparently due to the difficult issue of deciding where fair value lies, and will intervene at their discretion.
• The ECB’s holdings will not have seniority over private creditors.
• Unlimited purchases will be contained to maturities from one to three years: A large part of this debt is already being used as collateral under various liquidity operations, so the ECB are effectively promising to purchase an unlimited amount of a limited stock of outstanding debt.
• The OMT program is intended to repair distortions in government bond markets caused by what ECB President Mario Draghi described as ‘unfounded fears over the reversibility of the euro’.

Potential issues

• If a member state fails to comply with the conditions for aid agreed with the rescue funds, the ECB can stop making purchases or may even sell the bonds they have already bought.
• The key risk remains that a country enjoying the benefits of the regime could subsequently renege on its commitments, triggering potential market panic.
• The Bundesbank has remained openly opposed to the plan, refusing to move away from its established doctrine that central banks should focus solely on price stability.
• Focus could quickly shift to Spain’s reaction to the plan and its ability to set the terms of a widely anticipated rescue package.

Fidelity European Sovereign Credit Analyst, Tristan Cooper, said: “Draghi seems to have met market expectations today, which is positive given fears of a disappointment. Peripheral bond markets are appropriately rallying in response. The ball is now firmly back in the court of Spain, which must now sign up to a program or ‘enhanced conditions credit line’. Any prevarication would lead to a big sell-off, which Prime Minister Rajoy can ill-afford.
“Then the spotlight moves to Italy, which will find it very difficult to stay out of the program if Spain goes in. Why would anyone buy Italian bonds if the Spanish curve is being supported by the ECB and the EFSF?

“Draghi’s comments were marginally negative for Portugal and Ireland. Much of the recent buying in those markets has been premised on the ECB stepping in, in the short-term. However, Draghi stated that ECB support would only be forthcoming at the time when bond market re-access was envisaged under their existing Troika programs, which is next year for both.

“On balance, though a positive day for peripheral Europe.”

Fidelity Director of Asset Allocation, Trevor Greetham, commented: “The markets are right to respond positively to the potential for unlimited ECB intervention in peripheral bond markets with no seniority.

“It’s a good step towards debt mutualisation via the ECB balance sheet. Intervention, when it comes, could also trigger a pick up in business confidence in core countries as fears of a break up recede. The catch is that intervention to lower financing costs doesn’t make the periphery competitive and, in this debt crisis, austerity has generally led to economic weakness even when interest rates are zero.

“Banking union of some form could help spread the pain of peripheral economic and asset price weakness across the euro area, but my concern is that we’ll continue to see chronic economic divergences. In the end this is always going to come down to politics. Will lender countries keep lending? Will borrower countries stick to austerity? Does all of this engender full political union or deepen divisions?

“I expect Europe to muddle along but its economy won’t fire on all cylinders until these issues are resolved.”

Looking ahead
The US Federal Reserve Bank meets next week and Chairman Ben Bernanke will speak on Thursday. Investors are now wondering whether the Fed will also act – or continue to watch for improvement in the US economy and stubborn unemployment rate.

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