ECB Plan Not A Bull Market Guarantee

Includes: DIA, FXE, SPY
by: Evan Schnidman

Today's ECB meeting and ECB President Mario Draghi's press conference confirm that the ECB is going to explicitly enter the European bond markets. Although they framed this move as a plan to maintain price stability (control inflation) by limiting national borrowing costs, investors have already read this as a guarantee that the ECB will stabilize the eurozone and make sure the EU continues to exist. Although not inaccurate, this initial market reaction overstates the power of the ECB and disregards the tough road ahead.

Plan Details

The crux of the ECB bond-buying plan is that they now have "a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability." This means that Draghi has framed the whole plan as a way to control inflation, but he admits that the ECB program "will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro." So, Draghi has sold the plan to the Germans as a means for maintaining price stability in the eurozone even though the real purpose is to signal markets that the EU will persist in its current form, no matter what happens.

As Bloomberg News noted, the ECB plans to "sterilize" all bond purchases, therefore making the impact neutral to money supply. In other words, this is not QE. The ECB is not growing the balance sheet and this is not intended to be stimulus, only a backstop. Obviously this balance sheet neutrality was part of the deal to bring the ever-inflation hawkish Germans on board with the plan. While this step does not diminish the ECB's new power reduce debt costs in countries like Spain and Italy, it does not mean that the market should not see this as stimulus when it is really only intended as a guarantee that the EU will persist.


In essence, Draghi has declared that he now has a bazooka and he intends to use it to keep the eurozone together, the trouble is that he is not the trigger man. Spain, Italy and any other country that might need help reducing borrowing costs are the trigger men, but pulling the trigger is not costless to them.

The ESM/EFSF has strict conditions on the backstopping of debt. In fact, these conditions were developed jointly with the IMF to mirror conditions they have imposed on countries needing capital injections in the past. The problem is that the best indication of whether a country will require an IMF loan if whether they have gotten one is the past. Obviously this is largely due to structural weaknesses in the particular economy, but the IMF has even admitted that it is largely due to the conditions they impose on countries receiving these loans. They revised loan conditions in 2002 and again in 2009 to limit these destructive marcroeconomic policies, but they have yet to demonstrate that they have found the perfect formula and Spain and Italy seem like a very big stage to test out these new policies.


By announcing the details of the new bond buying program Mario Draghi restored his personal credibility and set up an explicit backstop for the eurozone. This is good reason for the markets to respond favorably. However, the announced plan is neither stimulus nor a guarantee that the countries in need will actually utilize the bond buying capability. This ultimately means that the strengthening of the euro is probably justified (although if the Fed does not announce QE next week, the euro will weaken), but equity markets have almost certainly gotten ahead of themselves. Equities will likely correct when investors realize that although theoretically more stable, the eurozone has no new liquidity at its disposal, only a backstop for its weakest economies.

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. I have no business relationship with any company whose stock is mentioned in this article.