ECB's New Proposal: First Thoughts

 |  Includes: EWI, EWP, SPY
by: Peter Tchir

A Small Step for Draghi, a Giant Step for ECB

The ECB's latest plan is interesting. It doesn't go as far as some would like, and it has problems in that once again everything has to be negotiated. At the same time, it seems like they have made a momentous change in attitude. They still aren't where the Fed is in terms of debt monetization, but the Fed didn't get there in a day either.

What I liked Most: Actionable

The proposal seems actionable within the existing framework. It doesn't need ESM. It doesn't need entities to get banking licenses. I thought Draghi did a superb job answering questions. He seemed to have thought out a lot of issues. If his initial "whatever it takes" comment was more spur of the moment, he was now prepared.

For one of the first times, they really seem to have gone through more details and thought about more potential outcomes. This felt like him delivering a plan and answering questions about a plan, more than him trying to say stuff to keep the markets happy.

What I liked Least: Multiple Party Involvement

I would have liked to see a plan where the ECB could act independently. A program where the ECB could just pull the trigger when it felt the time was right. The fact that the country has to work with the ECB and the IMF to put the plan in motion, and that it can be terminated, is concerning.

Pari Passu: Don't Believe It

While it was nice that the ECB is agreeing to remain a standard creditor, I don't really believe that. If in a year's time the economies are still in trouble and the ECB has accumulated a lot of debt, I would expect them to figure out a way to get better treatment. Having said that, I like that he is on record saying they waive it, because it shows they finally understand some of the market's fears. So while I don't believe it, I think their stance is reasonably positive for the market and shouldn't be a deterrent.

Conditionality: More Bark than Bite

I suspect that the IMF program will not be too onerous. That it may be closer to matching the "fiscal compact" countries have already agreed to. Some of the worst things in the Troika agreement with Greece were because Europe seemed to demand retribution. The IMF, assuming they lead, tend to be better at turning things around. Again, this language is likely there to make Germany less angry, while giving as much leeway to countries as possible.

Draghi made it clear that if Portugal and Ireland were back in the primary market, they could well qualify for this program based on their existing deals. We will see how heavy handed they are with conditionality, but I think they will make this relatively easy to achieve, at least initially.

Maturity: Typical Old School Banker

As I've said all along, it is generally easier to convince people to take credit risk at the front end of the curve. The perception that you can predict events 2 or 3 years out much better than 10 years is real. Generally, I don't like the risk/reward of playing the front end, but given the people the ECB has to appease/mollify, the strategy makes sense.

It also means they don't have to use as much money. Defending the entire curve would be expensive. Protecting the front end will require less ECB money. This will likely lead to some weird shaped curves, but not much you can do when the deep pocket says they buy "unlimited" but only until 3 years.

It does tie in nicely with LTRO maturities (expect an LTRO3 if they need it).

It seemed like it will be a rolling 3 year, so that today, they could buy bonds out until 2015, but next year, they could buy out until 2016. I didn't get exact confirmation of that during the press conference, but it seems consistent with what I have been able to sift through so far. That rolling nature is important, because if things are going according to plan, they are constantly prepared to protect out to 3 years.

An A for Effort, a C for Execution

The plan is at best a C plan. It doesn't compare to the Fed's plans. On the other hand, it is much better than their current plan which deserves the infamous F minus grade. The progress they made cannot be ignored. It is like they have purposely stepped onto a slippery slope with every intention of slipping further if they need to.

CDS Capitulation Day

CDS looks particularly one sided. It will move tighter and wider with stocks, but as a whole, I think buying interest here is minimal and we could see a nice gap tighter and significant outperformance versus other asset classes.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long EWP, EWI, but positions can change.