Draghi Buys Time With Sterilised Bond-Buying Programme

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The ECB kept its key interest rate unchanged at 0.75% and announced a new bond-buying program to save the Euro. Will it work and will it be enough? Those questions remain unanswered as Mario Draghi has, yet again, ommited much of the key detail, but for now, it seems investors are placated and today they embraced the extra risk and jumped feet first into equities.

At the ECB meeting, Mario Draghi announced a bond-buying program aimed at the secondary bond market which is named as Outright Monetary Transactions (OMT). According to Draghi, market participants are currently pricing the convertibility risk on yields from peripheral countries, a situation that is not acceptable and that should be addressed by the central bank. In order to eliminate such risk, the ECB will conduct open market operations to buy sovereign debt in the secondary market but without debasing the Euro and so avoiding an expansion of its balance sheet. In contrast to what happens in the US with quantitative easing, the ECB operations will be fully sterilised and are not seen as monetary expansion or easing. This particular detail is of high importance. Mario Draghi is not able to print money at this point and needs to “sterilise” any bond-buying intention to satisfy the will of 17 nations but it is a weakness in the program that may just bring it underwater and result in failure as happened with the program the ECB ran in 2010-11.

Draghi hasn’t given much detail on how the intervention would occur, at least, he hasn’t stated any cap on yields as many would wish him to do, similar to the EUR/CHF floor. As already stated in the press conference held in August 2, only countries that ask for help from the EFSF /ESM facility will be able to benefit from any ECB intervention. A country will need to ask for a full bailout or a precautionary program and adhere to the non-desirable austerity measures before benefitting from the ECB bond purchases. If, at any time, a country fails to comply with the adjustment program, bond purchases will stop.

The OMT program will target the short end of the yield curve and most bond purchases will be of debt with maturities between 1 to 3 years. Funds committed to the program are unlimited such that the ECB promises to keep buying debt until it eliminates convertibility risk. One important point advanced by Draghi regards seniority. The ECB will be treated “pari passu” with any other creditors.

The ECB put the ball in the hands of Italian and Spanish governments as these are the countries that can benefit the most from the program, and they will need to ask for help from the EFSF/ESM facility before the ECB steps in. We need to monitor closely what they will do over the next few weeks.

Traders seem to be happy with these terms as European equities rallied. The FTSE ended 2.11% higher, while the CAC 40 gained more than 3%. Bond Yields from peripheral countries benefitted the most as can be seen in the table below. As risks is deemed to fade, yields on German bonds will likely increase as happened today.

We believe that sooner or later there must be an agreement around issuing centralised euro bonds or engaging in a non-sterilised bond program. What the US has embarked perhaps too much on, the Eurozone hasn’t done yet, and yet the need here is much higher. Some currency debasement will be needed in Europe as a strong Euro is just an additional threat to growth.

Percentage movement in yields today

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