Written By: Alistair Wilson
Since the ECB press conference on 6th September, the market has generally taken the news positively, although the price moves in some sectors have been relatively muted. Primarily this was due to the ECB’s new policy actions, labelled “Outright Monetary Transactions” (OMTs) having been fairly well leaked to the market prior to Draghi’s address.
In summary we think Draghi delivered everything that he alluded to in July during his famous speech at the London Investment Conference. He may have been a bit light on some of finer details of the mechanics of the bond purchase strategy, which no doubt will disappoint some, but in our view these will be clarified over the coming weeks and the steps he announced are the most significant taken by the ECB since the crisis began.
We have long maintained that the ECB is key to containing the crisis currently engulfing the Eurozone. Past Governors may have erred on the side of caution – reluctant to “step on the toes” of the politicians. But Draghi has heeded the gravity of the situation and, according to some commentators, stretched the mandate of the ECB to tackle the problems head-on; almost Fed-like.
The plan adds scale to the crisisfighting tools, and importantly, the plan brings in some much-needed flexibility. Rather than stressed nations requiring a full rehabilitation programme, they can now request a “precautionary programme” which will deal directly with government bond yields in the secondary market. Under the new OMT program, the ECB will buy secondary bonds in whatever scale is required to bring yields down to whatever spread they deem appropriate for that sovereign. It is this unlimited scale that will drive fear into the bears and lead to capitulation of short positions, especially in Eurozone peripheral debt. Just as the adage says that “you can’t fight the Fed”, well it now seems there is another guardian in town not to be messed with. This is exactly what Draghi meant when he said it was critical to remove the convertibility in the market. As expected, the ECB are to target 1-3 year bonds only at this stage, but of course the change in sentiment will impact the whole curve. Another key element of the package was that purchases via the OMT will rank pari passu with other market creditors rather than rank senior to them, which has been a major irritant to market participants and rating agencies over the past few years of intervention.
We had expected this plan to apply only to new states requesting aid – i.e. Spain and Italy – but once again Mr. Draghi has gone a step further. States already receiving full bailout packages may request OMT assistance to help them return to the primary markets. This is important because the existing bailouts all have a defined end date and the Troika (EU/IMF/ECB) can only keep channelling rescue funds to these nations if it is reasonable to assume 12 months ahead that the nation will be able to fund itself at the end date. Portugal is nearly at that point, and may well have needed a second bailout, but this coupled with the great work done by the technocratic government over there, means that a second bailout is now unlikely to be needed. At least this point will please Mr. Wiedmann, who was the only dissenting vote for this new ECB master plan.
So unexpectedly Portugal is also a clear winner. If requested and activated, the Portuguese banks, who will all be large holders of their own government debt, will all be able to invest their liquidity assets with total confidence again, making the return to normal markets a strong likelihood. Of course, this will apply to any bank in a state that requests a precautionary programme, and therefore the programme is generally a benefit to banks as well as the sovereign. By way of an example to demonstrate the magnitude of this point, Banca Monte Dei Paschi, who has €25 billion of BTPs on its books, had to take a first half write down on this position of a staggering €5 billion due to the volatility of the Italian government debt in the second quarter. CEO Mr Profumo will no doubt have a big smile on his face this week as markets begin to re-price his BTPs to incorporate the possibility of ECB intervention.
Obviously the OMT is just a facility, and it requires a member state to request EFSF/ESM aid and the conditions that go with it, but if it does happen, the ramifications for asset prices can be drawn from the programme’s original intent.
Draghi wanted to remove “unfounded fears on the part of investors on the reversibility of the Euro”. In our fixed income market this fear had spread widely across many credit markets. Banks bore the largest brunt, but insurers almost equally so, and then most corporates that had any meaningful exposures to the periphery also experienced a large degree of credit widening. Not all of this will go away. As Draghi has previously stated, he can help with liquidity, but he can’t remove credit risk, although it does leave these assets with a favourable outlook
Lastly, we think it is just worth commenting on the lack of a rate cut. The consensus was for a 25bp cut. However, given that Draghi used the “excuse” that the transmission of monetary policy was broken to justify that the OMT was in the ECB’s remit, he could hardly then have a rate cut at the same time, because it simply would not work due to the transmission failure! Draghi did not say this, he merely stated that the governing council had anticipated the weaker conditions when making the prior cut. But given that the transmission of monetary policy is currently not working, we may have to wait for OMTs to begin before the next cut in rates, so a Euro recovery rally may well follow.
For the fixed income market bulls, who still seem to be in a minority, the ECB announcement could hardly have been better timed. We have noted recently that the market is not set up for a Spanish bailout, and a big technical squeeze on asset prices has already been underway throughout the summer. The origins of the squeeze go back to the start of the year where the consensus forecast for 2012 was for a repeat of 2011. A great start to the year followed by a second half of poor performance. This looked to be very much the case, albeit slightly early, when we had a failed Greek election and sovereign debt haircuts for the first time in the Eurozone. This left the market participants very short risk going into the second half. However, running a bear strategy generally costs money to maintain, as opposed to being a bull in fixed income, where just owning the market pays you a daily coupon. Therefore, a constant drip feed of negative news is required to sustain low bond prices.
Without that drip feed, the market was already improving when Draghi made his speech in London on July 26th. In particular, the cut in the ECB deposit rate in July forced banks’ cash mountains back into the market place where there was very little free float of inventory. Here is where the summer squeeze began. In general, most managers (buy- and sell-side) remained relatively short risk, and the August rally caught many offside.
Draghi then delivering on his promises last week has compounded the technical position in the market, and risk assets are being given a much needed lift. Fundamentally many fixed income assets, particularly credit assets, are still undervalued, so the rally could have meaningful legs.
So for now the ECB has done its bit, and the baton is firmly handed back to the politicians. The market is right to be confident based on what the ECB has done, but now we need the politicians to act too. The ECB has bought them time to fix their problems, but ultimately Europe still needs growth and reform before the crisis is over.