Assessment of the announcement by the European Central Bank
HONG KONG, 7 September 2012 – The European Central Bank’s (ECB) new ‘Outright Monetary Transactions’ (OMT) program will enable the ECB to make unlimited, sterilised purchases of sovereign bonds in the secondary market.
This latest move is unlikely to be the magic bullet markets are looking for to resolve the crisis, however, it should help contain peripheral yields at the shorter end of the curve.
- Bond purchases will be conditional: the ECB will only buy the sovereign bonds of countries that have entered an agreement with the euro area rescue vehicles (EFSF and ESM). The aim is to keep the interest rates of Spain and Italy from spiralling.
- No yield targets will be set: the ECB have stopped short of setting yield targets, apparently due to the difficult issue of deciding where fair value lies, and will intervene at their discretion.
- The ECB’s holdings will not have seniority over private creditors.
- Unlimited purchases will be contained to maturities from one to three years: A large part of this debt is already being used as collateral under various liquidity operations, so the ECB are effectively promising to purchase an unlimited amount of a limited stock of outstanding debt.
- The OMT program is intended to repair distortions in government bond markets caused by what ECB President Mario Draghi described as ‘unfounded fears over the reversibility of the euro’.
- If a member state fails to comply with the conditions for aid agreed with the rescue funds, the ECB can stop making purchases or may even sell the bonds they have already bought.
- The key risk remains that a country enjoying the benefits of the regime could subsequently renege on its commitments, triggering potential market panic.
- The Bundesbank has remained openly opposed to the plan, refusing to move away from its established doctrine that central banks should focus solely on price stability.
- Focus could quickly shift to Spain’s reaction to the plan and its ability to set the terms of a widely anticipated rescue package.
David Urquhart, the portfolio manager of Fidelity Asian Aggressive Fund, said, “If approved by the Germans, the bond-buying plan announced last night has the potential to provide some stability to the European sovereign bond markets. The objective of this new plan, called OMT (Outright Monetary Transactions) is expected to provide Sovereign states with benefits similar to those provided to European Banks via the Long-Term Refinancing Operations (LTRO) announced last year – lower funding costs, and improved availability of funds. High bond rates make it almost impossible for the heavily indebted sovereign states to deleverage, as the heavily indebted sovereign states need to issue more debt in order to pay the high interest cost. This initiative will still leave parts of Europe with low growth, high unemployment and continuing need to de-leverage but the announcement of the new plan has effectively boosted market sentiment, and provided a solution to the continuing refinancing requirements of certain sovereign states.
Chinese stocks in particular have been strong performers in today’s rally, as the Chinese NDRC (National Development and Reform Commission) website announced further stimulus measures. Plans were announced to build 2,018km of road, 9 sewage water treatment plants, and 2 waterway upgrades. This is in addition to approvals given on the 5th September for 25 new subway and inner-city rail projects worth 800bn yuan (US$126bn), to be spent over the next 6 years, until 2018. Chinese cyclical stocks as well as financials, energy and industrial companies were the strong performers in today’s rally. I remain overweight in China as current valuations of 8.5x next year’s earnings, remains a substantial discount to the historical average of 12.5x. At these low-multiples, there are some Chinese companies that provide a very favourable risk-return dynamic, a very pessimistic economic outlook is now well priced into Chinese stocks.”
Fidelity European Sovereign Credit Analyst, Tristan Cooper, said: “Draghi seems to have met market expectations, which is positive given fears of a disappointment. Peripheral bond markets are appropriately rallying in response. The ball is now firmly back in the court of Spain, which must now sign up to a program or ‘enhanced conditions credit line’. Any prevarication would lead to a big sell-off, which Prime Minister Rajoy can ill-afford.
“Then the spotlight moves to Italy, which will find it very difficult to stay out of the program if Spain goes in. Why would anyone buy Italian bonds if the Spanish curve is being supported by the ECB and the EFSF?
“Draghi's comments were marginally negative for Portugal and Ireland. Much of the recent buying in those markets has been premised on the ECB stepping in, in the short-term. However, Draghi stated that ECB support would only be forthcoming at the time when bond market re-access was envisaged under their existing Troika programs, which is next year for both.
“On balance, though a positive day for peripheral Europe.”
Fidelity Director of Asset Allocation, Trevor Greetham, commented: “The markets are right to respond positively to the potential for unlimited ECB intervention in peripheral bond markets with no seniority.
“It's a good step towards debt mutualisation via the ECB balance sheet. Intervention, when it comes, could also trigger a pick up in business confidence in core countries as fears of a break up recede.
The catch is that intervention to lower financing costs doesn't make the periphery competitive and, in this debt crisis, austerity has generally led to economic weakness even when interest rates are zero.
“Banking union of some form could help spread the pain of peripheral economic and asset price weakness across the euro area, but my concern is that we'll continue to see chronic economic divergences. In the end this is always going to come down to politics. Will lender countries keep lending? Will borrower countries stick to austerity? Does all of this engender full political union or deepen divisions?
“I expect Europe to muddle along but its economy won't fire on all cylinders until these issues are resolved.”
The US Federal Reserve Bank meets next week and Chairman Ben Bernanke will speak on Thursday. Investors are now wondering whether the Fed will also act – or continue to watch for improvement in the US economy and stubborn unemployment rate.
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