All eyes were on Mario Draghi yesterday as he laid out his latest plan to fix the nearly three-year long European debt saga. Although the event was a regular European Central Bank (“ECB”) rate announcement, markets were mainly focused on details of the ECB bond buying scheme that Draghi, the ECB president, mentioned in July.
The announcement revealed three surprising details about the program. First, the ECB plans to purchase bonds from one- to three-year maturity when the market expected a purchase of at most two-year maturities. It also promised to conduct “unlimited” purchases of troubled European bonds, underlining the ECB’s determination to keep the Eurozone together at all costs. Lastly, the ECB no longer counts itself as a senior creditor when buying these sovereign bonds. This means that when a country defaults on its sovereign debt, both private creditors and the ECB will receive the same treatment. During the Greek bailout, private creditors were forced to take a larger discount on their Greek bonds than the ECB, raising concern that any purchase of European debt will see private creditors on the losing end.
To the uninitiated, this announcement serves as the European Union’s quantitative easing (“QE”) exercise. Almost half a decade after the financial crisis broke out and the U.S. Federal Reserve released two QE exercises, Europe is still mired in its own sovereign debt crisis. Essentially, QE is a fiscal expansionary policy that attempts to promote growth by pumping money into the economy. In Europe’s case, the ECB is promising to utilize the printing press to print more money and purchase unlimited amounts of sovereign bonds of troubled Eurozone governments, so long as they accept reform conditions. By taking these bonds out of the market, the hope is that bond yields will reach more sustainable levels that countries can reasonably repay.
This fiscal expansion has been extremely effective for the U.S. as interest rates remain close to zero since the Federal Reserve launched its QE exercises. The ECB is hoping that its own version of QE, called ‘outright monetary transactions,’ will lower the interest rates that countries have to pay to borrow money on the debt market.
Not surprisingly, the effect on the markets has been instant. The S&P 500 closed on Thursday at a record high since January 2008, and Italian equities rose an astonishing four percent. Spanish two-year bond yield spreads over German bunds dropped below three percent for the first time since April from a high of seven percent, representing lessening fears of a default by the Spanish government. Furthermore, since Draghi announced last July that the ECB would do whatever it takes to keep the Eurozone intact, Italian two-year bond yields have drastically declined from five percent to around two percent.
Will it Last?
Unfortunately, like so many times over the last three years, we can expect market euphoria over this latest announcement to wear off. Firstly, the troubled governments of Spain and Italy have yet to decide whether they will apply for the program. Considering that ECB’s latest rescue plan is conditional upon recipient governments agreeing to strict austerity measures, it might be politically unpalatable for Spain or Italy to accept help. Furthermore, assuming that the troubled governments swallow their pride and accept ECB aid, the markets are expected to test the ECB in its resolve for unlimited bond purchases to hold yields down.
For example, in 2010, the Swiss government promised to defend the Swiss franc by intervening in the foreign exchange market to prevent it from appreciating too much. The market saw the Swiss Central Bank’s hesitation to defend the currency and the Swiss franc initially continued to appreciate. Europe could very well find itself in such a position if the ECB fails to convince markets of its resolve to defend the Eurozone.
Written by SiHien Goh