It is an understatement to say that financial markets are anxiously awaiting the details of the European Central Bank’s policy decision tomorrow. That decision is likely to boil down to a confirmation of the ECB’s intention to buy government bonds of the so-called “weak” members of the eurozone.
Ahead of the announcement, there have been the inevitable snippets of information and well-informed reports that suggest European Central Bank president Mario Draghi will deliver a workable policy proposal. The market is ready to embrace bond purchases by the ECB, which is an important part of Draghi’s “we’ll do whatever it takes” attitude to hold the eurozone together.
That market assessment showed up, somewhat perversely, in a failed bond auction in Germany. The €5 billion bond auction attracted only €3.93 billion of bids from investors, which has been interpreted as a sign that those investors are allocating more of their cash to the higher yielding, but soon to be supported “weak” economies, rather than locking money away in the low-yielding German bond market.
This bond auction failure did not help the mood of German policy makers. German Finance Minister Wolfgang Schaeuble again voiced his ongoing scepticism, suggesting that financing government debt is not part of the European Central Bank mandate. Schaeuble again noted “price stability” as the ECB’s main policy objective. These comments are along the same lines as Bundesbank president Jens Weidmann who seems to be more worried about inflation than a break up of the eurozone.
But the Germans are increasingly isolated in their objections to the likely European Central Bank bond purchasing program. Failure to help the weak countries is likely to be more costly than temporarily bending the interpretation of the ECB mandate to prevent a sovereign default. That said, the Germans have influenced some of the details of the likely bond purchase program. Any member country being assisted by the ECB bond-buying action will have to meet strict conditions on fiscal austerity and debt reduction to qualify for the assistance.
There are several striking aspects of the likely European Central Bank policy action. The bond-buying program will be unlimited, meaning that the ECB can (and probably will) be in the market and acting as if there is an implicit ceiling on bond yields. If the market pushes yields higher, for whatever reason, the ECB will be there to cap and then reverse the rise. What that ceiling is for each country is not yet clear, but the open-ended nature of the ECB proposal is a clear signal that there cannot be a disruptive bond sell-off that in normal circumstances would threaten a sovereign’s ability to finance its deficit and, in turn, threaten default. In other words, the weak countries of the eurozone will have no trouble financing their budget deficits while they implement the fiscal austerity packages.
Another important aspect of the likely European Central Bank announcement is that the bond-buying program will be limited to bonds out to three years’ duration. The ECB will not be helping to fund long-term debt. At this stage, this implicit time limit on the bailout package means that the weak countries need to sort out their fiscal positions relatively quickly. In other words, when the bonds need to be refinanced — by definition within a three-year timeframe — the government in question will have had to have moved its fiscal position to a standing that will allow it to reissue bonds but at a rate that investors outside the ECB will be willing buy. This will only happen if there is clear and unambiguous progress in fixing the budget and sovereign debt problems.
One aspect of the European Central Bank policy which is not yet clear, is whether the bond purchases will be “sterilised” from the money supply. To sterilise the bond purchases, the ECB would need to withdraw liquidity from a different part of the economy so that the money supply does not increase. If this does in fact form part of the package, it would clearly be a concession to the Germans, but it would also undermine the stimulatory impact of the government bond purchases.
In anticipation of the ECB action, markets have been driving bond yields lower. Since late July, the Spanish two-year bond yield has fallen from just under 7% to 3.25% today. It is a similar picture for Italy when its two-year bond yield has fallen from 5% to 2.45%. The euro is also strong, trading about $US1.2600 this morning, which is up about 3.5% in the past few weeks.