ECB Bazooka Unwrapped – Another New Acronym Is Born

Irish finance minister Michael Noonan once quipped that all that was required to circumvent the legal restrictions faced by the ECB regarding the implementation of a 'QE' type policy was for 'someone to come up with a clever formula'.


“From our perspective, we see how the Bank of England operates, and we see how the Fed operates, but I understand it’s not legally possible for Frankfurt to operate in the same way,” said Irish Finance Minister Michael Noonan as he arrived at yesterday’s meeting.“So we’ll have to see if somebody has come up with a clever formula to allow that.”

 

(emphasis added)

This was uttered in late November of 2011. In an interview he gave to RTE Radio in Dublin earlier the same month he had already specified what exactly he had in mind:


The ECB needs to “go into the market and say ‘We have a wall of money here and no matter how much speculation there is, we’re going to keep buying Italian bonds or any other euro bonds that are threatened.”

 

Noonan's prayers have been heard. Someone has indeed come up with a 'clever formula'. A new acronym has now entered the into the ever lengthening dictionary of euphemisms for money printing: the 'OMT', or 'outright monetary transaction'. Luckily it has led to the termination of another such term, namely the 'SMP', so at least acronym inflation has been held in check somewhat.

The ECB under Mario Draghi has spent the past few months redefining the precise meaning of its mandate. Lo and behold, it has turned out that all sorts of things can be subsumed under 'preservation of price stability'.

They include 'ensuring the smooth functioning of the monetary policy transmission mechanism', which is new-speak for 'the markets have to bend to our will and our will is to implement a one-size-fits-all interest rate across the entire euro area as determined by the central bank'. Also found in the seemingly so narrow mandate was the need to 'counter irrational speculation against the irreversibility of the euro'.

Obviously, without the euro, there won't be an ECB. Since all bureaucracies are first and foremost concerned with their own survival and growth, it is only logical that the ECB regards the emergence of a 'convertibility premium' as an existential threat it must overcome.

Following are the features of 'Operation OMT':

 

Conditionality

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.

 

Coverage

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above. They may also be considered for Member States currently under a macroeconomic adjustment programme when they will be regaining bond market access. Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

 

Creditor treatment

The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

 

Sterilisation

The liquidity created through Outright Monetary Transactions will be fully sterilised.

 

Transparency

Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.

END BLOCK (emphasis added)

A few comments on the passages emphasized above:

 

Regarding conditionality:

Activation of 'OMT' is contingent on the countries concerned relinquishing their fiscal sovereignty. Clearly the crisis is the stepping stone toward a European Superstate, just as former Italian prime minister and president of the EU commission, the socialist Romano Prodi, predicted in an interview he gave to the FT in December 2001. Said Prodi:


“I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now.But some day there will be a crisis and new instruments will be created.”


In the press conference Draghi noted that the precise shape and form of the conditions would have to be hatched out by governments and that it was not the ECB's job to do that. However, the ECB is part of the so-called 'troika' which oversees implementation of the conditions. It is not really credible that it has no input at all on the concrete form they will take. In any case, the ECB will wield a giant carrot and stick once Spain and Italy apply for a bailout. It seems we can kiss the EU's subsidiarity principle good-bye, unless they balk and decide to actually ditch the euro.

 

Regarding coverage:

This was the phrase that presumably caused the considerable excitement in the financial markets we witnessed yesterday. „There will be no ex ante quantitative limits“ – i.e., 'we will buy however much it takes'.

 


 

Spain's two year government bond yield continues to decline sharply in the wake of the ECB's bazooka announcement – click for better resolution.

 


 

Spain's 10 year government bond yield has finally joined the party as well, falling back below the 6% level – click for better resolution.

 


 

Regarding creditor treatment:

The fact that the ECB subordinated private sector creditors in  the forerunner of the 'OMT', the now defunct 'SMP' was a major reason why the latter failed so utterly. Ranking other creditors pari passu is designed to remove a reason for them to sell everything they have to the ECB.

 

Regarding sterilization:

This is the sop thrown to the sole dissenter, Bundesbank president Jens Weidmann. It has apparently gone unnoticed in Germany, where 'Die Welt' complained about 'Financial Markets Cheering the Death of the BuBa' (link to Google translation here).

Obviously, if all 'OMT' purchases are indeed sterilized, then they will be one step removed from outright inflationary financing of governments – however, this should also create considerable doubt about their chance of success ('success' as defined from the point of view of the central planners). 

Among the objectives of central bank intervention is always – whether they admit it like Ben Bernanke has lately done or not – the goosing of asset prices. After all, the only way an artificial boom can be set into motion is if relative prices in the economy are distorted by setting the rate of interest below the natural rate – and this in turn requires flooding the loan market with fiduciary media.

A fully sterilized bond buying program cannot alter the growth of the money supply unless private banks regard it as an incentive to step up their own inflationary credit creation. In fact, not even an unsterilized 'QE' program is a guarantee for a growing money supply as the Bank of England as recently found out. If bonds are mainly bought from banks, then there is a chance that they will simply redeposit the excess reserves thus created with the central bank – in which case none of the newly printed money leaks out into the economy. To the extent that the central bank buys assets from non-banks, new deposit money will be created immediately, along with new bank reserves.

Obviously though, full sterilization means that the purchases will not influence money supply growth directly. As we have frequently pointed out, euro area money supply growth, though lately accelerating a little bit, has slowed to a Japanesque, snail-like crawl. It is therefore a bit surprising that stock markets around the world were celebrating the decision to the extent they have:

 


 

The DJ Euro-Stoxx Index soars after the ECB announcement – click for better resolution.

 


 

No Change In Interest Rates, But Collateral Eligibility Widened Further

Obviously there was little point in altering the ECB's administered interest rates, which are already at rock bottom levels, so they skipped that (this also leaves the ECB with a little leeway to eventually 'do more') . 

However, collateral eligibility was eased once again and to a very considerable extent. Henceforth euro area banks may even pledge collateral denominated in foreign currencies. The decisive point however is the waving of all ratings thresholds for government-issued scrip:


Change in eligibility for central government assets

The Governing Council of the ECB has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the central government, and credit claims granted to or guaranteed by the central government, of countries that are eligible for Outright Monetary Transactions or are under an EU-IMF programme and comply with the attached conditionality as assessed by the Governing Council.

The suspension applies to all outstanding and new assets of the type described above.

The decision on the collateral eligibility of bonds issued or guaranteed by the Greek government taken by the Governing Council on 18 July 2012 is still applicable (Decision ECB/2012/14).

Expansion of the list of assets eligible to be used as collateral

The Governing Council of the ECB has also decided that marketable debt instruments denominated in currencies other than the euro, namely the US dollar, the pound sterling and the Japanese yen, and issued and held in the euro area, are eligible to be used as collateral in Eurosystem credit operations until further notice. This measure reintroduces a similar decision that was applicable between October 2008 and December 2010, with appropriate valuation markdowns.

These measures will come into force with the relevant legal acts.

 

(emphasis added)

In other words, even if a government issuer is utterly insolvent and its bonds are rated accordingly, banks are free to pledge such toxic waste with the ECB in order to obtain funding. So there is no longer any pretense that the central bank will be eschewing to take on too much risk on its balance sheet. That notion has always been a farce anyway, but now it has finally been officially acknowledged.

All public statements to date regarding the euro-system's duty to take care of the keeping risk profile of its holdings in check have thus been revealed as meaningless – which of course they always were.

 

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2 Responses to “The ECB Waves Its Magic Wand”

  • They get enough junk on their books, the Euro could be shorted into oblivion

    • jimmyjames:

      They get enough junk on their books, the Euro could be shorted into oblivion

      ***************

      I’m thinking that is what Jens Weidmann is looking at too-a currency crises erupting from this-
      Draghi is so full of himself he likely thinks they can just implement a “no shorting ban” if such an event does occur-

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