The 2012 prize for the most notable market moving event in Europe can be comfortably assigned to the announcement of the European Central Bank’s (ECB) Outright Monetary Transactions (OMT) programme. The prize is even more deserved when we consider that although OMT has not been actively implemented yet, the yields of two-year Spanish government bonds have moved from a peak of 6.6% in July 2012 to 2.6% in January 2013 (see Figure 1).
This spectacular performance has been driven by a real change in investors’ behavior. Foreign investors, who were moving their savings away from peripheral countries since the summer of 2011, started to move them back into peripheral countries – slowly, but steadily. Data on net private capital flows from Eurosystem’s TARGET2, an interbank payment system for the real-time processing of cross-border transfers throughout the European Union (EU), show this trend (see Figure 2).
This astonishing move led some European policymakers to go as far as saying that the worst part of the developing situation in the eurozone is behind us. We should not, however, forget that OMT is not a solution, but just a tool to buy more time, with its effectiveness depending on how it is leveraged. We even would argue that the optimal way to use OMT is as a preventative tool, not as an active tool. A country like Spain should ask for support preemptively and use OMT for what it really is: a watchdog for sovereign yield spreads that can bark loud although it may not bite hard.
To assess OMT’s effectiveness, let us analyze it from four points of view:
- ECB willingness
- Yield target
- OMT limitations
- Sequence of implementation
ECB President Mario Draghi has used words such as “whatever it takes” and “believe me, it will be enough” during his most recent crusade to preserve the euro, which started with his now famous Global Investment Conference speech in London on 26 July 2012. While we should not expect Mr. Draghi to use weaker words than he used, we think that he really is serious when he says it. He means it. Believing in the ECB, however, is no more than an act of faith. The skeptical investor should investigate whether there is something more in addition to words.
A lot has been said about the fact that OMT has no ex-ante quantitative limits and that the ECB will be pari-passu (treating all parties the same) with private investors. For bullish investors, these programme characteristics are enough to make sure that OMT will work if needed. It is assumed that the unlimited purchase of bonds under OMT will succeed in crowding-in private investors; an objective at which the ECB’s previous programme, the Securities Market Programme (SMP), failed miserably. This type of potential behavior is also known as “the ECB can and will go all in as needed”.
However, size potential is not the only variable that counts to succeed in crowding-in investors, as the SMP has already shown. It is worth reminding that the SMP2’s size (the second installment of the ECB’s SMP, which focused on Italian and Spanish government bonds and was in place from August 2011 to January 2012) was sufficient to absorb the gross issuance needs of Italy in the third and fourth quarters of 2011 but it was still not able to stop Italian yields increasing from 5% to 7%.
In the first weeks of the SMP2, there was a belief that the ECB may have been targeting a limit close to 5% on 10-year maturities. The failure to defend such a limit created doubts about the existence of such a limit, triggering a flight to safety from private investors. Without an explicit yield target, it was impossible to convince investors that Italian 10-year bonds at 7% were a great opportunity under the SMP. Given the failure of SMP, it would seem natural for OMT to define some sort of yield target. But so far discussions about whether the ECB will defend a specific spread have resulted in no conclusive answers. This leaves investors to decide ex-ante about the real effectiveness of OMT in the absence of an explicit yield target.
While we believe that members of the ECB board understand this issue and some of them would like to have some form of transparent target, we also think that the absence of such a target is justified by the need to self-limit OMT by design for two reasons. The first is incentive structure: It can be argued that the guarantee of low yields would dis-incentivize a country from implementing much needed and painful structural reforms. The second is that it can also be argued by opponents of the ECB’s government bond-buying programmes that imposing a cap on yields could be a form of government financing, which is forbidden under international treaties. The absence of an explicit target may therefore be justified to make sure that OMT cannot be criticized.
There are also other explicit limitations. First, for a country to benefit from OMT, a strict and effective conditionality attached to an appropriate European Stability Mechanism (ESM) programme is necessary. Second, the country must have access to the primary market. And third, OMT will focus on the short part of the curve only – that is, up to three years of maturity.
Taken at face value, these additional limitations make OMT look much more constrained than the SMP. But is it really true? These limitations actually are strategic steps to protect the existence of OMT. The need for a country to come under the ESM programme gives the ECB the excuse not to be involved in fiscal policy, while the need to maintain access to primary markets gives the ECB an excuse not to provide market financing. Finally, the maturity limitation means that the ECB will focus only on the monetary policy spectrum. When considered all together, these limitations are actually protecting OMT from critics.
Sequence of implementation
Given current market levels, the ECB’s strategy seems to be one of “wait and see”. Countries such as Spain think that at current levels the ECB will not actively buy their government bonds because of the self-imposed lack of a yield target. Politicians prefer not to do anything in order to have a last bullet to fire in case of sudden spread widening. But is this the best strategy?
Let us imagine what would happen if spreads widen and investors start selling: The widening momentum is likely to build up between the initial signs of spread widening and the time the ECB actually starts intervening. There is also the risk that the widening would trigger all kinds of unintended consequences, including the risk of rating downgrades. If that is the case, it is possible that only a full “all-in” response by the ECB could reverse the selling flows. But an unconstrained “all-in” strategy means removal of self-limitations and risks attracting critics among member countries, potentially even within the ECB’s Governing Council. Those critics would make things more difficult and uncertain, and potentially (not necessarily) lead to failure as it happened with SMP.
On the other hand, if the ECB could intervene very early in the spread widening, it is reasonable to think that a smaller amount of intervention would be needed to convince investors the ECB is serious. A full “all-in” strategy may actually never be needed. The value of OMT is not in tightening spreads actively from here, as Spanish politicians wish, but in keeping spreads from widening again.
The situation in Spain is far from being solved as demonstrated by the recent spread volatility due to growing rumors of inappropriateness by Spain’s political leadership. The country’s hesitance to embrace the OMT programme and simply wait for spreads to widen, hoping for the best, risks that the ECB’s stance on conditionality may harden, commitment from the core will weaken, investors’ confidence will waver and that financial risks heighten.
The spread tightening achieved in the last six months has been the result of Mr. Draghi’s poker playing skills. It is a better strategy for Spain to maximize its probability of success by cutting the left tail risk via applying to the OMT now and continuing the bluff, rather than waiting for the big widening.