Thursday has come and gone and we know the details of the ECB's bond buying program. Of course in reality the plan was leaked ahead of time and, not surprisingly, Goldman seemed to know exactly what the ECB was going to say and telegraphed it to clients at around 5 a.m. Wednesday morning. In any case, the new plan, dubbed Outright Monetary Transactions, or, OMT (add a new acronym to your central bank alphabet soup vocabulary), provides for unlimited purchases of 1- to 3- year sovereign debt in the secondary market dependent upon the beneficiary's acceptance of
...conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme.
The purchases will be fully sterilized, the ECB will provide weekly and monthly summaries of its purchases with the monthly summaries set to show the country-by-country breakdowns. Finally, the ECB will participate pari passu basis with other creditors -- that is, there is no seniority attached to the ECB purchases.
So far, quite a bit of attention has fallen on the idea that the ECB will 'sterilize' its purchases. Although the word 'sterilization' has found its way into many of the headlines of articles discussing the ECB's plan, there doesn't seem to be much in the way of explanation as to how that process works or even if it will work at all.
There exists quite a bit of precedent for the ECB sterilizing purchases of sovereign debt. Purchases made as part of the ECB's other bond buying facility, the Securities Markets Programme (SMP), are sterilized when
...the Eurosystem re-absorbs the liquidity provided through the SMP by means of weekly liquidity-absorbing operations. The intended amount for absorption equals the cumulative size of settled SMP transactions at the end of the preceding week.
These liquidity-absorbing operations take the form of fixed one-week term deposits which are auctioned by the ECB. Banks bid on these deposits and the ECB accepts bids until it has soaked-up an amount equivalent to the amount of bonds it has purchased (rounded to the nearest half billion).
That sounds good in principle, but note that it isn't up to the ECB how many banks bid for these deposits. As JPMorgan reminded investors in a research note from December of last year, there are essentially three options for what banks can do with the new reserves they receive when the ECB buys bonds:
...a bank...has three alternatives. First, it can shift excess reserves into the ECB's deposit facility, where it would currently earn 0.5% overnight. Second, it can try to lend the funds out in the interbank market, where it would currently earn around 0.6% overnight but where it would also face some credit risk. Third, it can try to put the funds into the ECB's fixed-term deposit facility for one-week at the expense of slightly reduced liquidity.
So ultimately, it is up to the banks where they put the new money. Notice also that should the ECB go this route for sterilizing the new purchases, banks do have an extra incentive to bid for them that they did not have when the above-cited note was published: the ECB overnight deposit rate is now 0%.
In any event, the ECB hasn't always been successful in soaking-up the excess liquidity injected into the system via bond purchases. Notably in June 2010 and in November of 2011, bids for the term deposits came-up short by around 23 billion euros and 9 billion euros respectively. Over all, the ECB has failed to sterilize its purchases on at least six separate occasions. The problem is that banks are the most unwilling to part with their cash when anxiety peaks which of course is likely to coincide with spikes in periphery short-term yields. In other words, the bond buying is likely to coincide with cash hoarding, raising considerable doubts about the ECB's ability to 'soak-up' the liquidity it pumps out. In turn, this raises the possibility that the ECB will fail to soak-up enough of the excess cash to keep inflation expectations in check and to keep its credibility from being questioned.
Furthermore, it isn't exactly clear how the 'new' program differs from the existing program other than the duration of the assets purchased. This is really just SMP 2.0. Of course there is the conditionality of the participants, but investors should remember that none of the supposed recipients has agreed to participate. All in all, this certainly isn't the bazooka the market was hoping for, but it does represent more central bank intervention which has of course sent risk assets including equities and periphery bonds soaring. One certainly wonders: why the euphoria? Not only was the ECB's program leaked days in advance, but those hoping for balance sheet expansion didn't get it (at least not by the design of the program). As ZeroHedge notes,
Spanish bonds [are] soaring on hope Spanish bonds will plunge to allow Spanish bonds to soar on ECB purchases.
The irrationality in the market represents a travesty with no historical equivalent: amid a faltering economic recovery and 8.3% unemployment, U.S. stocks are at four and a half year highs while the EuroStoxx 50 is back near its year highs just as 88% of clients polled by Goldman Sachs expect Spain will need a bailout before the end of the year. This is entirely central bank driven -- the market is taking its cues solely from policymakers. Call it what you will, but eventually reality will overtake this rally as there are no fundamentals behind it. I'm not the only one who thinks so. From Citi's credit research department:
I'm a little cautious on how much further this rally goes...One recurring lesson of the last few years is that the threats of central bank intervention tend to be far more effective than the actual programs.
The more stocks rise, the more you can make by betting against a steep decline. I (still) recommend shorting stocks (SPY) and staying long volatility. Remember, even Ben Bernanke has said that monetary policy is no panacea.