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Christopher Mahoney
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I spent eight years at Bank of America in New York (1978-86) covering Wall Street, then moved to Moody's Investors Service where I worked for 22 years, covering banks, sovereigns and corporates. I chaired the Credit Policy Committee for four years. I retired in 2007 as vice chairman.
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  • Draghi Declares Eurozone Risk Premia "Unacceptable" 0 comments
    Aug 14, 2012 12:14 AM

    "The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. 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. [What does "fundamental manner" mean in a case like Greece?] The euro is irreversible.

    "In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist - with strict and effective conditionality in line with the established guidelines. [In other words, using the Greece/Portugal/Ireland template which includes deep structural reforms in addition to austerity.]

    "The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective." [What objective?]

    ---Mario Draghi, President of the ECB: Introductory statement to press conference following the ECB board meeting:, Frankfurt am Main, 2 August 2012

    Those are President Draghi's words and my interjections. The reason his remarks seem to be inscrutable is because he wanted his remarks to be inscrutable. He used a lot of words to tell us almost nothing.

    Draghi says that risk premia on government bonds resulting from fears of exit/default are "unacceptable". Unacceptable to whom? Certainly not to real-money bond investors. Is he saying that the ECB will guarantee that such risks do not exist?, or that the ECB will take steps to reduce such risks?, or that somebody else ought to be doing something about it? He doesn't say.

    Draghi says that such fears must be addressed in a "fundamental manner". That can mean anything. Notice his use of the passive voice: "are unacceptable", "need to be addressed". This is like saying that catastrophic earthquakes are unacceptable and need to be addressed. I think what he means to say is that "risk premia that are related to fears of the reversibility of the euro are difficult for us to fix right now, and so they need to be addressed by the governments themselves by proving that they can implement the troika's diktats to the letter and for years to come". In other words, "the ball isn't in my court".

    Then he goes on to articulate his conception of a third ECB mandate: That it will perform its policy duties toward countries only if they comply with third-party dictates. The analogy would be if the Fed were to condition monetary easing on US compliance with the IMF's fiscal recommendations. No compliance, no easing.

    Once again, Draghi appears to be picking up the hand grenade and tossing it back to the PIIGS. "If you lose weight and get exercise, then I will consider prescribing blood pressure medicine, but not before. Otherwise you'll just go on binging on donuts and coke."

    What this means, on a practical level, is that Spain must formally apply for a bailout from the Troika. If she applies, and if the ECB thinks that she intends to comply with the Troika's diktat, then the EFSF and the ECB may resume buying Spanish bonds. How much, a lot or a little? Draghi: "of a size adequate to reach (our) objective". What objective? Price stability? The elimination of risk premia? We don't know because he doesn't know: half of his board wants to rescue Spain and the other half isn't so sure (see below).

    So the guidance we have is that, if the Spanish government agrees to surrender fiscal sovereignty to the Troika (which it has pledged not to do), then maybe the EFSF/ECB will buy some amount of its bonds.

    If Spain signs the surrender documents, the EFSF/ECB will probably buy some of itsbonds, the risk premia will stay up, and the ECB will say they did what they could. For the ECB to erase the risk premia it will have say that it is prepared to buy all of Spain's debt. Well, how about that idea? Here's one answer:

    European Central Bank bond purchases won't solve Spain and Italy's difficulties maintaining investor confidence, ECB Governing Council member Luc Coene said in an interview with De Tijd and L'Echo.
    Bond yields have been rising because financial markets don't trust Spanish and Italian authorities to take the measures necessary to repair their economies, Coene said in the interview, published today in the two Belgian newspapers. As a result, he predicted few benefits from any ECB action.
    "It makes no sense for the ECB to start financing those countries," said Coene, who also heads Belgium's central bank. "It would only lead to the ECB taking on the whole public debt of Spain and Italy onto its balance sheet. That would in turn weaken the ECB and do nothing to resolve the underlying problems".
    --Bloomberg, Aug. 10th, 2012

    So there you have it: from "whatever it takes", to "how about this?" to "oh, just forget it".

    Europe is now in suspended animation for the August holidays; nothing is supposed to happen until they are back next month.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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