Will we see yield/spread targeting by the ECB?
August 24, 2012 9 Comments
This week, the rumor that the ECB is planning on yield or spread targeting has been mooted and denied so many times I’ve lost count. We will presumably find out more about this when we hear from Mario Draghi after the ECB governing council meeting on September 6th. In the meantime, falling peripheral short- and long-term bond yields would suggest that investors are betting the rumors are true. With so much upside already priced into the bond markets regarding ECB intervention, the room for disappointment is substantial. Will the ECB engage in a yield or spread targeting exercise? It might, but I doubt we’ll be told about it.
Mario Draghi was one of the first to indicate that the ECB might engage in yield or spread targeting on August 2nd at the ECB governing council press conference. He highlighted that the ECB thinks that some countries (ahem, Spain and Italy) are having to pay elevated borrowing costs because of concerns about convertibility, and that this was hindering monetary policy transmission. As he put it: “Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner.”
One way to unblock the monetary policy transmission channel is therefore for the ECB to eliminate the risk premia that stems from convertibility risk. This would require the ECB to have some idea of what it thinks borrowing costs should be for countries needing ECB intervention if there weren’t a concern about countries exiting the eurozone (EZ). It should come as no surprise then that the ECB might have some yield or spread targets in mind.
Will the ECB announce these targets? I doubt it. First, the only way for the ECB to credibly defend a yield or spread cap would be if it were willing to intervene in an unlimited fashion. Otherwise investors would view it as an invitation to bet against the yield/spread target and sell their peripheral sovereign debt while there is a buyer. Mario Draghi was vague in his response when asked whether the ECB would reactivate its Securities Markets Programme (SMP) in a limited or unlimited fashion, but the central bank may not be willing to take on the credit risk associated with unlimited sovereign debt purchases.
Even if the ECB were willing to intervene in an unlimited fashion, conditionality and yield/spread caps are fundamentally incompatible. The ECB has been adamant that it will only purchase the bonds of those countries that have already signed up to the conditionality attached to EFSF/ESM support. If the ECB precommits to a specific yield or spread target, what happens when that country fails to meet the terms of its conditionality? If the ECB were give up the yield/spread target, then it would lose credibility and investors would rush to bet against the cap. If it didn’t abandon the target, then countries receiving ECB support would no longer be incentivized to undergo the painful adjustments being demanded of them. Germany and other core countries would likely find the resultant moral hazard unacceptable.
Finally, an announced yield target would severely reduce the ECB’s flexibility in terms of deciding when and how much it plans to intervene. The ECB’s independence would be seriously compromised as a result, an issue with which various members of the governing council might take umbrage.
Hopes are high for what the ECB might announce on September 6th. The danger is that anything short of the full monty–explicit yield or spread targets with unlimited bond purchases at all points on the yield curve—will be considered a disappointment and will inspire a sell off just as we are entering an extremely turbulent month in the EZ.