Monday, August 20, 2012

If This Report Is True, The ECB Is Actually Getting Close To Firing Off The Bazooka

If This Report Is True, The ECB Is Actually Getting Close To Firing Off The Bazooka:
mario draghi ecb european central bank
There's a story by Reuters citing the latest edition of German magazine Der Spiegel, which is reporting that the ECB is considering setting an explicit top yield threshold for peripheral nation borrowing costs at its meeting in September.
In other words, ECB chief Mario Draghi would come out and say something like: "Italy's 2-year borrowing costs shall not be more than 300 basis points above Germany's 2-year borrowing costs, and if it rises above that level, the ECB will come in and press it down via bond purchases."
It would be an incredible game changer for traders to know that the ECB was sitting there on the bid at a certain level, standing ready to buy sovereign debt.
That the ECB would eventually do something like this has been buzzed about for a long time, but speculation really started heating up in late July, when Mario Draghi came out and said that high peripheral borrowing costs were impeding the transmission of monetary policy, and thus came under the purview of the ECB.
He further hinted at something like this at the August meeting, when he talked about making purchases at the short end of the yield curve, offering the market a very clear idea that more action was on the way.
The problem with the ECB committing to keeping a nation's borrowing costs low (or relatively low) is that it creates a moral hazard problem. If Italy knows that the ECB will fund it at X.XX%, Italy's inclination may be to borrow and spend as much as possible, knowing there will be no ramifications in the market.
Thus for the ECB to come in and take this step, it also needs countries like Spain and Italy to submit to conditionality (a request for official aide, outside supervision, hard deficit targets, and so forth).
That's why the markets last week were so enthused by growing chatter that Spain would officially request outside help. If Spain does that, then the ECB can then step in and use its unlimited might to smite the bond vigilantes.
Of course, there are a bunch of moving parts. What you're reading here is a report about a report about a report from one German magazine.
But what's critical is that the right ideas are starting to filter intl the right places.
A hard yield threshold would be an incredibly powerful tool, because assuming that the ECB wanted to keep its credibility, investors would know that the threshold would not be violated. Unlike previous ECB bond buying (which was expensive and ineffective) this would be effective and inexpensive, because in all likelihood the ECB would have to do very little actual purchasing, having properly set the market's expectations (See also: The Swiss National Bank's floor for the EUR vs. CHF).
The September meeting will be interesting.
SEE ALSO: Who really won the Euro ?

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