Central Bank Policy Implementation and the ECB's Plan
In order to avoid the appearance that its plan to buy bonds of peripheral governments does indeed amount to 'funding of governments by the printing press', the ECB has tied the plan to the condition that it has to happen in parallel with EFSF/ESM rescues. However, that was not all – there was another stipulation mentioned by Mario Draghi during the press conference. We briefly remarked on this already in our summary and analysis of the ECB decision last week.
The other part of the plan, which is supposed to make the operation more akin to a 'monetary policy' type intervention, is to concentrate the buying on the short end of the yield curve. The thinking behind this is that in 'normal times', the central bank is mainly aiming to manipulate overnight rates in the interbank funding markets as well as other very short dated interest rates rates. Hence intervention in the short end of the curve closely resembles this 'normal' implementation of monetary policy. With this, the ECB probably also tries to differentiate its actions from those of the Fed and BoE.
Usually, the central bank determines a 'target rate' for overnight funds, and whenever credit demand wanes and interbank rates drift below this target, it is supposed drain liquidity. Whenever credit demand threatens to push interbank rates above the target rate, it will add liquidity.
During boom times, very little 'draining' tends to happen. As a rule, central bank target rates will be too low, and as speculative demand for short term credit keeps increasing during a boom, its liquidity injections – which provide banks with the reserves required to keep the credit expansion going – will aid and abet the growth in credit and money supply initiated by the commercial banks.
In the euro area, this method of overnight rate targeting has produced roughly a 130% expansion of the true money supply in the first decade of the euro's existence – about twice the money supply expansion that occurred in the US during the 'roaring twenties' (Murray Rothbard notes in 'America's Great Depression' that the US true money supply expanded by about 65% in the allegedly 'non-inflationary' boom of the 1920's).
This expansion of money and credit is the root cause of the financial and economic crisis the euro area is in now. This point cannot be stressed often enough: the crisis has nothing to do with the 'different state of economic development' or the 'different work ethic' of the countries concerned. It is solely a result of the preceding credit expansion.
Since long term interest rates are essentially the sum of the expected path of short term interest rates plus a risk and price premium, the central bank's manipulation of short term rates will usually also be reflected in long term rates.
In the euro area's periphery, the central bank has lost control over interest rates since the crisis has begun. The market these days usually expresses growing doubts about the solvency of sovereign debtors by flattening their yield curve: short term rates will tend to rise faster than long term ones. This in essence indicates that default (or a bailout application) is expected to happen in the near future. It is possible that this effect has also influenced the ECB's decision to concentrate future bond buying on the short end of the yield curve. However, as is usually the case with such interventions, there are likely to be unintended consequences.
The Rollover Problem
Recently the bond maturity profile of Italy and Spain looked as depicted in the charts below. Note that the charts are already slightly dated (this snapshot was taken at the beginning of the year), so there may have been a few changes in the meantime, but they probably still represent a reasonably good overview of the situation:
Italy's debt rollover schedule, 2012-2021 – click chart for better resolution.
Spain's debt rollover schedule, 2012-2021 – click chart for better resolution.
There has been an enormous shift in the maturity schedule of the debt of both governments when we compare these charts to the situation as it looked in May of 2010, when the following snapshots were taken:
Italy's debt rollover schedule as it looked in May of 2010 – click chart for better resolution.
As of mid 2010, Italy had €168.2 billion of debt coming due in 2012. At the beginning of 2012, this had increased to € 319.6 billion – a near doubling. In Spain, the change is even more extreme:
Spain's debt rollover schedule as it looked in May of 2010 – click chart for better resolution.
In mid 2010, € 61.2 billion of bonds were expected to mature in 2012. At the beginning of 2012, this number had swelled to €142.2 billion.
What accounts for this enormous change? When interest rates began to rise sharply, the governments of Spain and Italy ceased to issue long term debt, opting to shorten the maturity spectrum of their debt instead. This was done because long term interest rates had become too high for their taste. It was no longer considered affordable to finance the government at these rates when they exceeded 6% and later temporarily even 7%.
Thus panic began to set in when short term interest rates began to rise sharply as well in November of 2011 and again from March 2012 onward.
Spain's 2 year government bond yield – it was the increase in these short term rates that made it impossible for Spain's government to continue financing itself without help – click chart for better resolution.
Now we can already see what the problem with the ECB's plan is: it will tend to shorten the average maturity of peripheral debt even further once it is implemented. In fact, it already has this effect even before the ECB has bought a single bond, as rates on the short end of the curve have recently fallen sharply in reaction to the announcement.
“European Central Bank President Mario Draghi’s bid to bring down Spanish and Italian yields may spur the nations to sell more short-dated notes, swelling the debt pile that needs refinancing in the coming years.
“In a way what the ECB has done is making the situation worse,” said Nicola Marinelli, who oversees $160 million at Glendevon King Asset Management in London. “Focusing on the short-end is very dangerous for a country because it means that every year after this they will have to roll over a much larger percentage of their debt.”
The average maturity of Italy’s debt is 6.7 years, the lowest since 2005, the debt agency said in its quarterly bulletin. The target this year is to keep that average at just below seven years, according to Maria Cannata, who heads the agency. In Spain, where the 10-year benchmark bond yields 6.94 percent, the average life is 6.3 years, the lowest since 2004, data on the Treasury’s website show.
“Driving down the short-dated yields provides a little bit of comfort and encourages Spain and Italy to issue more at the short-end,” Marc Ostwald, a strategist at Monument Securities Ltd. in London, said. “The problem is that you are building up a refinancing mountain.”
Even if the ECB buys the bonds of Italy and Spain, they will still have to repay them and regularly roll them over at maturity. By inducing them to shorten the average maturity of their debt further, the ECB creates new risks, especially as the economic downturn remains in full swing and is likely to worsen the fiscal situation of both countries in the short to medium term.
Interestingly, a similar shortening of average debt maturities can be observed in the euro area's 'core' countries. France is certainly considered a 'core' country and is currently treated as a 'safe haven' by bond investors. However, this is a tenuous situation, as it can still not be ruled out that the government will eventually be called upon to bail out the country's banks. At the moment all is quiet on that front, but it was only in November last year when the market was extremely worried about the risk these banks face in view of their enormous balance sheets and potential funding problems.
France also has the vast bulk of its debt rollovers scheduled for 2012 – click chart for better resolution.
A similar tendency to shorten the government's debt maturity profile can be oberved in Germany:
Germany's debt rollover schedule, 2012-2021, as of the beginning of the year – click chart for better resolution.
Now, Germany and France are obviously not expected to have problems rolling over their debt in the near term. The problem is rather that all these countries compete for the same investment funds. In other words, the shortening of the average debt maturity in France and Germany indirectly puts more pressure on the periphery, as the total of debt rollovers in the euro area has become much larger than it was previously.
It is of course no wonder that the German treasury is eager to sell lots of debt maturing in two years or less: investors are currently stomaching negative yields on this debt, i.e., the actually pay Germany's government for the privilege of lending it money. This may be great for Germany's government finances, but it it not without risk either. After all, given that Germany is the euro area's 'paymaster', it has taken on a huge and ever growing amount of guarantees. What if the crisis worsens and Germany's guarantees are called in? In that case it could turn out that it was a big mistake to take on so much short term debt just because it looked extraordinarily cheap.
The ECB's bond buying plan meanwhile is going to pile on even more rollover risk.
All in all we are left to conclude that the euro area's governments have exposed themselves to additional risks that could have been easily avoided.
The history of the ECB's now defunct 'SMP', via 'Der Spiegel' – click chart for better resolution.
Interest rates in the UK: the BoE has also lost control over rates to some extent. There is a growing gap between the 'target rate' and the rates charged to various types of bank customers. Chart via – click chart for better resolution.
Charts by: BigCharts, Der Spiegel, Ed Conway
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
3 Responses to “The ‘Maturity Crunch’”
Most read in the last 20 days:
- A Striking Chart
The Economy and the Stock Market As long time readers know, we are always paying close attention to the manufacturing sector, which is far more important to the US economy than is generally believed. In terms of gross output it is the largest sector of the economy, and it should of course be obvious that saving, investment and production are the only ways to create wealth. What's left of the Brooklyn Domino Sugar Refinery. Photo credit: Paul Raphaelson Contrary...
- Trump and Putin Narrowly Escape Assassination Attempt
The Gloves are Coming Off First a little bit of recent history. Readers are probably aware that some questions about the occasionally malfunctioning Deep State android... no, wait, we'll start again. Questions have recently been raised about the health of presidential candidate Hillary Clinton by various “alt-right” tinfoil hat-wearing conspiracy theorists, such as this one. The monsters are normally hiding under Hillary's bed, but lately they have come out into the open...
- US Economy - Curious Pattern in ISM Readings
Head Fake Theory Confirmed? This is a brief update on our last overview of economic data. Although we briefly discussed employment as well, the overview was as usual mainly focused on manufacturing, which is the largest sector of the economy by gross output. Pepsi factory in Baltimore, 1956 Photo via pinterest.com Readers may recall that we have pointed out for some time that there was quite a large gap between the data reported in regional Fed manufacturing...
- Why the Fed Destroyed the Market Economy
What Have You Done for Me Lately? Swing voters are a fickle bunch. One election they vote Democrat. The next they vote Republican. For they have no particular ideology or political philosophy to base their judgment upon. The primacy of the wallet. They don’t give a rip about questions of small government or big government. Nor do they have any druthers about the welfare or warfare state. In effect, they really don’t care. What’s important to the...
- How is Real Wealth Created?
An Abrupt Drop Let’s turn back to our regular beat: the U.S. economy and its capital markets. We’ve been warning that the Fed would never make any substantial increase to interest rates. Not willingly, at least. Groping in the dark, Yellen-style Each time Fed chief Janet Yellen opens her mouth, out comes a hint that more rate hikes might be coming. But each time, it turns out that the economy is not as robust as she had believed... and that a rate hike isn’t...
- Janet Yellen’s Shame
Playing Politics In honest capitalism, you do what you can to get other people to voluntarily give you money. This usually involves providing goods or services they think are worth the price. You may get a little wild and crazy from time to time, but you are always called to order by your customers. In the market economy, consumers reign supreme. There is no such thing as a “lost” vote in the marketplace; every penny spent affects production. Mises noted: “Consumers...
- Get Ready for a New Crisis – in Corporate Debt
Imposter Dollar OUZILLY, France – We’re going back to basics here at the Diary. We’re getting everyone on the same page... learning together... connecting the dots... trying to figure out what is going on. The new three dollar bill issued by the Apprehensive States of America. We made a breakthrough when we identified the source of so many of today’s bizarre and grotesque trends. It’s the money – the new post-1971 dollar. This new dollar is green. You...
- The Economy, the Stock Market and the Fed
John Hussman on Recent Developments We always look forward to John Hussman's weekly missive on the markets. Some people say that he is a “permabear”, but we don't think that is a fair characterization. He is rightly wary of the stock market's historically extremely high valuation and the loose monetary policy driving the surge in asset prices. The S&P 500 Index and the NYSE advance-decline line. Most market internals weakened steadily until early February 2016, but...
- Hanjin Marooning in San Pedro Bay
Global Trade Reversal Expansions and contractions in global trade have played out over long secular trends for thousands of years. The Silk Road, for example, was established by the Han Dynasty of China in 130 BC, and allowed for continuous trade between East and West for nearly 1,600 years. In addition to economic trade, the Silk Road was also a conduit for culture and knowledge among its network of civilizations. A map of the main ancient Silk Road - click to...
- Donald’s Electoral Struggle
Wicked and Terrible After touting her pro-labor union record, the Wicked Witch of Chappaqua rhetorically asked, “why am I not 50 points ahead?” Her chief rival bluntly responded: “because you’re terrible.”* No truer words have been uttered by any of the candidates about one of their opponents since the start of this extraordinary presidential campaign! Electoral map (note that the coloration may no longer be applicable...) That Hillary Clinton is...
- Great Causes, a Sea of Debt and the 2017 Recession
Great Cause NORMANDY, FRANCE – We continue our work with the bomb squad. Myth disposal is dangerous work: People love their myths more than they love life itself. They may kill for money. But they die for their religions, their governments, their clans... and their ideas. Famous French hippie and author Voltaire. He wears the same sardonic grin in every painting, whether he's depicted at a young or an old age, doesn't matter. His real name was François-Marie Arouet; he...
- The Donald Versus Killary: War or Peace?
War: A Warning from the Past Although history does not exactly repeat itself, it does provide parallels and sometimes quite ominous ones. Such is the case with the current U.S. Presidential election and the one which occurred one hundred years earlier. The Donald probably has the better slogan... The dominating question which hung over the 1916 campaign was whether the country would remain neutral in regard to the horrific slaughter which was taking place on the...