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Marcuard's Market update by GaveKal Dragonomics
On Wednesday, the eurozone is likely to inch a step closer to quantitative easing when the European Court of Justice hands down its preliminary ruling on the legality of the European Central Bank’s programme of Outright Monetary Transactions proposed in 2012. While the ECJ is expected to find that the OMT lies within the ECB’s competence (to use Euro-jargon), any qualifications it makes will go a long way to determine the shape of a eurozone QE programme that the ECB could announce as early as next week.
OMT and QE are not the same beasts, but both involve buying sovereign debt. OMT is an as yet unused policy under which the ECB would buy the sovereign bonds of a troubled member state going through an adjustment programme. The main aim would be to prevent bond yields from rising to unaffordable levels, with the ECB sterilising its purchases to control liquidity. Last year, the German Federal Constitutional Court ruled that the programme went beyond the ECB’s mandate, on the grounds that eurozone rules prohibit the central bank from funding individual states.
In contrast, QE would involve the unsterilised purchase of government bonds and would not be linked to reforms in any given country. Nevertheless, the ECJ’s answers to two key questions could impose major restrictions on the design of a potential ECB asset purchase programme:
1) Does QE represent fiscal as well as monetary policy? For example, if the ECB bought Italian bonds and Rome subsequently defaulted, the ECB could suffer a loss requiring recapitalisation by its members, or in other words European tax payers. If purchases of government bonds were unlimited, the cost to taxpayers could be incalculable. At the same time, by driving sovereign bond yields lower, the ECB could override the market forces that pressure governments into implementing reforms, exacerbating the risk of moral hazard.
2) Would ECB bond purchases amount to debt mutualisation? That would constitute a step towards fiscal union that Germany vehemently opposes. Moreover, under Article 125 of the Lisbon Treaty it is illegal for one member to assume the debts of another.
It is likely that the ECJ will rule largely in favour of the ECB, accepting the central bank’s argument that the OMT, even though unused, was a valid tool enabling the ECB to achieve its monetary policy goals. The announcement of OMT in 2012 clearly stabilised markets and lowered bond yields helping the ECB achieve another one of its mandates, the survival of the euro. The ECB couches its advocacy of QE in similar terms, portraying it as a monetary policy tool designed to lift growth and inflation expectations and counter the risk of stagnation or even a self-fulfilling deflationary spiral as businesses and consumers cut investment and spending in response to a worsening economic outlook.
An outright rejection of OMT from the ECJ would severely damage hopes for QE, undermining the ECB’s credibility and sending eurozone risk assets into a tailspin. Yet the ECJ’s unqualified backing is far from guaranteed. Given that the German Federal Constitutional Court has the power to stop Bundesbank participation in a programme that it thinks breaks EU law, the ECJ cannot afford to ignore its concerns completely. That makes implementing a viable scheme of asset purchases to flatten curves and force yields lower even trickier. Not only must the ECB design a programme that operates across nearly 20 sovereign yield curves, all with different curvatures and different spreads to bunds, it must also accommodate German concerns about risk sharing and moral hazard.
It has three main points to consider:
1) Will the central bank buy bonds in proportion to countries’ outstanding debt or in proportion to their shareholding in the ECB? Countries with high debts, such as Italy, benefit more from the former; those with lower debts from the latter.
2) How will the ECB address the German risk sharing concerns? One way would be to assign bond purchases to national central banks, which would individually bear the risk of default. That way the Bundesbank would not be exposed to any potential default by, for example, Italy or Greece. The drawback is that this option would implicitly accept the possibility of default, and would run counter to the principle of greater eurozone integration. Alternatively, the ECB could buy bonds of certain credit ratings, such as AAA or investment grade only, to minimise the risk to its balance sheet. Buying investment grade only would exclude both Greece and Portugal (both of which have parliamentary elections this year). Buying AAA bonds only would require significantly larger purchases to force down the yields in peripheral markets.
3) Where on the curve will the ECB buy? It would make little sense to buy bonds with negative yields, so purchases of German debt would most likely take place in the middle to long end of the curve, while purchases across the curve would be more likely in peripheral markets.
The difficulty of designing a programme that solves all these problems leaves plenty of room for the ECB to underwhelm, especially since the German members of the central bank’s governing council remain firmly opposed to QE, not just for the reasons outlined above but because they don’t believe it can work.
As a result, the ECB’s governing council may face an unpalatable choice between overruling its Bundesbank members or sending markets into a vicious tailspin should QE exclude Italian and Spanish bonds, or fall short of the expected EUR 500 bln.
To position themselves for either possibility, investors should consider going long German, Spanish and Italian 30-year bonds, in the proportion 50% bunds and 25% each in Spanish bonos and Italian BTPs, in a balanced approach similar to that long advocated by some analysts. If QE underwhelms, German bunds would benefit from a risk-off move, while if the ECB delivers, Spanish and Italian bonds will rally. A mix of the three should successfully reduce the portfolio risk going into this month’s key European decisions.
