The ECB, Monetary Financing, And The Unfolding Greek Tragedy

Includes: FEZ
by: Colin Lokey

Allow me to present "risk on" versus "risk off" in chart form. The following graphic shows the yield on Greek 10-year bonds over the last two days:

Chart: ForexPros

What the graphic shows is a 130 basis point compression before the positive parliamentary vote on the new austerity package and a corresponding 130+ basis point move wider less than 24 hours later triggered primarily by the rather catastrophic news that despite the vote, troika officials still may not disburse the next tranche of aid.

The main concern is that next Friday, Greek must make a 5 billion euro bond payment to the ECB -- Athens simply doesn't have the money. According to the Financial Times,

" senior official said the European Central Bank, which holds the €5bn in debt due next Friday, is resisting rolling the payment over, putting pressure on all sides to reach a deal quickly."

Note how ridiculous this is. The very same thing happened in August when Greece faced a 3.2 billion bond payment to the ECB. The solution devised by Mario Draghi and company at the time was to raise the limit regarding the amount of Greek T-Bills the Bank of Greece could accept as collateral for loans, essentially allowing the Greeks to issue worthless T-Bills in exchange for euros which would then promptly be paid back to the ECB in the form of a bond payment.

This is of course the very definition of monetary financing. The ECB simply allowed Greece to issue more T-Bills for fresh euros and in the absence of a quick agreement in Brussels on Monday, this tactic will likely be employed again so Greece can make its debt payment. In the Q & A session following Thursday's ECB policy meeting, Draghi was asked point blank how the central bank could possibly continue to encourage this charade:

"QUESTION: (inaudible) Dow Jones Wall Street Journal. Next week, Greece will have to refinance 5 billion in T-bills, and that's likely to be done again through emergency lending assistance. How much longer is the ECB going to tolerate that sort of behavior? And also, could you please explain to me why that's not a form of monetary financing?" (emphasis)

Draghi relied upon the same flimsy logic he relied upon in explaining why the ECB's promise to purchase unlimited Spanish and Italian bonds doesn't amount to monetary financing: the supposed short-term nature of the policy response:

"DRAGHI: Well, we - we consider this financing to be temporary. We don't consider emergency lending assistance to be monetary financing. It's considered amongst our instruments."

This is merely rhetoric however. It is abundantly clear at this juncture that the ECB is propping up governments with its policies and there really isn't much attempt to hide it anymore. This makes it especially absurd that the central bank should equate a restructuring of its Greek debt with monetary financing while at the same time printing euros and handing them to Greece so Athens can repay its bonds. Does Mario Draghi really think anyone would look less favorably on an ECB restructuring of its Greek holdings than they do on the perpetual extension of ELA?

There are two takeaways here. First, the ECB is engaging in monetary financing when it utilizes emergency liquidity assistance to help Greece pay-off its bonds and the central bank is also running a circular funding scheme in the process as the money Greece gets from ELA goes right back to the ECB for bond payments. So for those who assert that central bank balance sheets are never truly in jeopardy, note that the ECB is now paying off bonds owed to itself.

Second, the events unfolding in Greece and in the market for Greece's debt illustrate a point I made in a previous article about hedge funds' contention that Greek debt is a solid investment. I'm not sure 260 basis point swings in 48 hours are exactly what you want to see from your fixed income investments. Investors should stay short European equities (NYSEARCA:FEZ) and periphery debt. This is far from over.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.