October 6th, 2017

Fixed Income Note

ECB QE neither a tool to surpress peripheral yields nor a ‘bailout’ of the South

A word of warning on the ECB supposedly “suppressing” yields in Southern Europe. Don’t make the mistake that ECB QE is in any way suppressing yields in Southern Europe in particular. By design – capital key based buying – the ECB can effect yield levels of certain member states relative to other member states. But the ECB cannot – I repeat – cannot suppress them. The latest Catalonia-induced bout of volatility is a case in point. Spanish bonds have come under pressure regardless of ECB buying. If Catalonia truly were prepared to take a leap into the unknown and separate from Spain – really a case of mutually assured destruction for both Spain and Catalonia – the ECB would be powerless to stop the stampede out of Iberian assets. I would go so far to say that the ECB would even fuel the sell-off by the ‘printing’ of central bank reserves through the QE program. It allows for a larger outflow of capital than would be possible without such central bank buying. The key thing to remember is that the ECB buys only a limited, fixed amount of Spanish debt. The same applies for the terminated SMP bond buying program that the ECB ran from 2010 to 2012. The ECB bought a large but limited amount of bonds in order to “safeguard” the monetary transmission mechanism. But spreads blew out regardless as investors off-loaded their exposure onto the ECB. Only when the ECB promised – with Chancellor Merkel’s blessing – to buy all the bonds regardless of price or the supply in the market (Draghi’s “whatever it takes” and OMT program) did yields and spreads come down.

 

An analogy with the Bank of Japan’s QE program comes to mind here. The BOJ switched to yield-targetting from monetary base expansion. Yield targetting means that the BOJ is willing to buy or sell potentially unlimited amounts of bonds in order to meet its 10y JGB yield target. See how it cannot target monetary base expansion at the same time? This is the famous Tinbergen rule: you can only have one policy objective for each policy instrument.

 

Bottom line: ECB QE is monetary base expansion only and no yield-targeting policy (like BOJ QE) or a put option for investors (the OMT). The end of QE does not mean that peripheral spreads have to widen – Portuguese spreads are even narrowing despite QE’s end coming closer, and despite the fact that the ECB is skirting the issue/issuer limit for Portugal.