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Another Attempt To Heal The Euro: Outright Monetary Transactions

Since the beginning of the financial crisis, major central banks became the center of attention. Conventional monetary policies created a low interest rates environment - in order to boost growth and job creation, interest rates of major developed countries have gradually been cut to levels close to zero, giving no more room for further easing. As a result, policy makers had no other choice than extending their methods and implementing the so-called "unconventional" measures or in other words non-standard monetary policies.

From traditional to alternative healing therapies

In the USA, the Fed has implemented so far 3 rounds of quantitative easing (QE) and an extended Operation Twist, where the main objectives were to shore up the real estate market and inject liquidities in the economy in order to create growth and jobs.

In Europe, in a response to the liquidity problems and the spreading of the sovereign debt crisis, the European Central Bank (ECB) has introduced in May 2010 its first Securities Markets Programme (NYSE:SMP). Due to the intensification of the Greek crisis and the risks of contagion, the ECB increased the number of its interventions - reactivating its bond purchases under the SMP, organizing refinancing operations, lowering the minimum reserve requirements for banks and extending the list of collateral accepted for refinancing operations.

The Diagnosis

As the uncertainty in the markets heightens, the risk of default of certain euro member states such as Spain, Portugal and Greece increases and market participants demand a higher risk premium for purchasing these nations bonds, making it unbearable for these countries to finance themselves.

Due to the negative relationship between bond yields and bond prices, a weaker demand for troubled nations' bonds pushes their prices down and increases their cost of borrowing. In other words, their access to the financial markets is restricted because their yields climbed toward unsustainable levels around 7%. This phenomenon makes the payment of their debt considerably difficult especially in a situation when these countries are experiencing difficulties to generate growth.

The ECB found that in some countries, the current yield levels of financing are extremely exacerbated and decided on September 6, 2012 to launch a new program - the so-called Outright Monetary Transactions (OMT), aiming to ease the tensions on the bond markets. Within this program, the ECB is engaged to intervene in the secondary bond market by purchasing securities in order to re-establish the troubled countries' access to the financial markets.

What outcome to expect?

The new European scheme represents unlimited purchases of sovereign bonds with maturities of one to three years, which will be fully sterilized, with no specific yield target and the ECB will have no seniority.

In details, the ECB will buy sovereign bonds of countries that request help and sign up to an appropriate EFSF/ESM macroeconomic adjustments program. The central bank will offer an open-ended commitment to continue purchasing bonds as long as the country respects the conditions. All these actions will be offset with an immediate selling of other securities (treasury bills, bonds) in order to avoid any money creation meaning that this is not a quantitative easing. Thus, by neutralizing the impact on money supply, the ECB minimizes the risks of induced inflation and of further increase in the size of its balance sheet. Furthermore, the central bank is giving up its seniority to be the first one to be paid back if something goes wrong.

After the announcement, responses from markets were overwhelmingly positive - the Euro surged to a 4-month high against the USD, all major indices were in the green and government bond yields decreased.

Nevertheless, a few questions and critics were arising regarding the effectiveness of this new rescue plan. First, the ECB, in effort to prevent moral hazard, is supposed to intervene and to continue intervening only if the conditionality is respected. However, would the central bank stop its actions if one member state does not comply with its promises? Second, taking into account that OMT is targeting on the shorter end of the curve, what will happen if long term securities yields remain high at unsustainable level? And another negative of the new plan is that, due to legal restrictions, it cannot be implemented quickly.

There are a number of questions around the effectiveness of the new program, however the general idea of the ECB is to buy some time for countries in trouble in order to implement measures to correct their fiscal imbalances and apply structural reforms. One thing we can be sure is that monetary policies are not suitable for resolving structural problems; they only pave the way for better conditions to implement reforms.

The bond market reacts

As we mentioned before, the announcement of OMT itself, had a positive effect on markets. It has almost been a year since Mario Draghi assured investors about the Euro irreversibility and presented the plan without it even being used once. Since then, we have seen a significant drop in 10 year government bond yields in troubled countries such as Greece, Spain, Italy and Portugal.

Greece 10 year government bond yield

Italy 10 year government bond yield

Italy

Portugal 10 year government bond yield

Spain 10 year government bond yield

In countries with solid fiscal discipline like Germany and France, government bonds kept being strongly demanded as safe haven assets although they were not bearing a significant return.

Germany 10 year government bond yield

France 10 year government bond yield

The bottom line is that even though Outright Monetary Transactions were never put into action, the new scheme helped troubled countries to reacquire access to the financial markets without paying an exacerbated risk premium, and therefore, allowed the euro, among other things, to regain confidence.

A simple idea had more effect in partially easing the tensions in the financial markets than many other actions taken by the European Central Bank, however we have to be realistic and remember that the European sovereign debt crisis is far from over.

Written by Peter Dimitrov

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