22nd August 2012
In most years we would now be in the middle of the summer lull but it would appear that in the credit crunch era the disappearance of many in the Northern Hemisphere to the holiday resorts and beaches has not had its usual effect. Although it would be wrong to say that it has had no effect at all because many markets have been suffering from low volumes. However behind the scenes much has been going on and there have been quite a few developments and changes.
The European Central Bank
The debate over the future role of the European Central Bank has continued. The hints from its President Mario Draghi that it might not only restart its bond-buying programme but do so on a larger scale have generated a lot of heat and hot air. For example the German board member of the ECB Herr Asmussen was translated by the Financial Times as explaining why a new bond buying programme would work:
"Because it will be better conceived than the old bond-buying programme, the Securities Markets Programme."
Okay let us recall the Securities Markets Programme
When the SMP was introduced in May 2010 it was part of the "shock and awe" programme for Greece brought in by Euro area leaders. As you can see by the "shock and awe" description it was supposed to fix matters. In reality backing hype with bond market purchases in Greece worked for around a fortnight as her government bond market rallied in response to ECB buying. As the summer developed prices fell and yields rose in spite of substantial further purchases by the ECB.The best one can say about the SMP is that it may have delayed the price fall. With the benefit of time we can now say that over a 2 and a half year timescale it failed as Greek ten-year bond yields at 24.5% are more than double those that caused the SMP to be introduced.
The ECB has tacitly admitted its failure by the backdoor way in which it has give itself a profit from its bond buying. For example it owned the Greek bond which matured this week and got back 100 for it by allowing Greece to issue more Treasury Bills. Nice. If you think of this from the Greek perspective there has been no gain at all and in fact it can be argued this led to a loss for them. By this I mean that otherwise this bond would have been part of the debt haircut or PSI scheme and they would have paid more like 70% than 100%. That would have saved them just under one billion Euros which they desperately need in their time of crisis.
The failure of the SMP was not due to a lack of size as the ECB purchased around 55 billion Euros of Greek government bonds. Post debt haircut this rose towards 20% of the Greek central government debt but as you can see this did not make any significant change to her yields.
Moving Forwards: Yield targeting
The most extreme suggestion has been that the ECB will set yield targets for the government bonds of Euro area countries which hit trouble. It will then defend these yield targets by bond purchases to cap the yields as these levels. The obvious question is why did nobody think of this before? The answer is that they did as this was the implicit plan for Greece which was then applied to Ireland and Portugal. This failed to cap the bond yields there and failed again when applied to Spain and Italy. The only country which seems to have stabilised near any sort of potentially viable level is Ireland.
Remember this has been an environment that has been extremely favourable for bond yields and they have plunged in many countries. If we use the UK as a benchmark we see that as the SMP began the ten-year Gilt yield had just dipped below 4% and right now it is less than half that at 1.68%. So the SMP needs to be set against a benchmark of falling yields even in a country -as I described yesterday- with its own building deficit and debt issues.
How will things be different this time?
Herr Asmussen talks of this:
"A state must make a request and carry out comprehensive economic reforms."
The problem I have with that is the difference between this new "conditionality" and the old:
"I welcome the agreement in Athens with the Greek authorities of a multi-annual programme of fiscal consolidation and structural reform"
The above quotation is from European Commission President Barosso and it is from May 2nd 2010. And as ever it did not lack hyperbole and anti-prescience:
"This assistance will be decisive to help Greece bring its economy back on track and preserve the stability of the Euro area"
So to sum up the "conditionality" will have to be a lot more effective this time and it will have to do so in an unfavourable economic environment. The Euro area economy shrank in the second quarter of this year and that looks like to continue in the third.
The other possibility is that the ECB will buy more bonds this time. However as I pointed out above it intervened in Greece on a substantial scale. So if we consider Spain in isolation and her 735 billion Euros of central government debt plus her regional debt we may be looking at purchases which equal the whole SMP so far. The around 220 billion of SMP purchases led to two German members of the ECB resigning as it was. But this would not be alone because if Spain saw her bond yields fall to more sustainable levels would not Italy (central government debt starting to nudge 2 trillion Euros) want the same? Portugal (184 billion Euros) might argue why not it too? As it is already in a support programme and operating "conditionality".
More on MIndful Money:
To receive our free daily newsletter sign up < a href="http://mindfulmoney.co.uk/register" target="_blank">here