As September draws closer, investors are becoming increasingly anxious about the feasibility of the ECB's plan to buy short-end Spanish and Italian bonds. While there has been quite a bit of media coverage regarding the potential for the ECB to establish rate caps (and by extension, to implicitly sanction limitless money printing) on periphery debt, there hasn't been much discussion as to the mechanics of the actual purchases. Nomura has taken the time to analyze what the plan might look like and the Financial Times reviewed the group's analysis, identifying some important points.
One is reminded very quickly that the ECB is now tripping over its own previous attempts to solve the crisis. For instance, Nomura notes that the best course of action may be to purchase the bonds from Spanish and Italian domestic banks as opposed to international banks. The logic here is that if the ECB purchases bonds from banks outside of Spain and Italy, these banks may be so happy to be rid of the toxic debt that they will not be willing to buy anymore of what Spain and Italy are selling.
On the other hand, if the purchases are made from Spanish and Italian domestic banks, the assumption is that these institutions will then have breathing room to buy more debt from their sovereigns which will stimulate demand and work to keep yields suppressed after the initial ECB purchases. That sounds good in principle but as Nomura notes, Spanish and Italian banks may be running a bit low on short-dated Spanish and Italian bonds because they pledged them all to the ECB as collateral for cash. So, in yet another irony of ironies (Europe keeps them coming), the ECB effectively already has the bonds it is trying to buy.
Another troubling thing about this scenario is that presumably Spanish and Italian banks will see the average maturity of their sovereign bonds rise. This would be the case if Spain and Italy attempt to take advantage of the situation to sell longer-term debt to their countries' banks while the window of opportunity remains open. This puts the banks in a precarious situation. The longer the average maturity of a bond portfolio, the greater the negative impact on prices when yields rise. Therefore, if yields on Spanish and Italian 10s should rise sharply, the negative implications for the banks may be magnified if they hold a greater percentage of long-term debt as an indirect result of the bond buying program.
In any case, one can see from this brief analysis that the problems facing Italy and Spain are by no means going to go away if and when the ECB decides on the specifics of its bond buying plan. As I have outlined above, there are some very serious obstacles to implementation and it isn't exactly clear how this is going to work given all of the other mechanisms already at play (LTROs, the forthcoming Spanish bank bailout, etc.). Investors shouldn't be overly optimistic about the prospects for this. I recommend: 1) Staying long volatility (VIX) as a hedge against any hiccups in the ECB's bond purchase plan and 2) maintaining a healthy degree of skepticism towards any 'fix' that doesn't involve the word 'austerity'.
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