The ECB surprised the market with a repo status quo (in spite of the confirmation that the euro zone GDP declined by 0.2% in Q2) but delivered an OMT (Outright Monetary Transactions) programme that was broadly in line with the press leaks over the past few weeks. The ECB also widened the list of eligible assets for collateral: a sign that it believes this should be much more effective than lower rates in incentivizing banks to grant more loans. Yet the respite for banks remains limited as it focuses solely on "the minimum credit rating threshold".
The press release insists strongly on the "strict and effective" conditionality that comes with OMT. This is what Draghi called the "second leg" that was missing in the now-terminated SMP. This sentence sums it up (paraphrased): "if governments fail to comply, we won't continue with the program." If Italy and Spain need help (the former for liquidity reasons and the latter for solvency reasons), they will have to apply to an EFSF/ESM or IMF assistance program.
Beyond that, the OMT focuses on the short end of the curve (1-3 years), giving up its preferred creditor status that was one of the shortcomings of the SMP (SMP remains senior but any new purchase under OMT will now be pari passu with private investors). The seniority renouncement is a strong (tentative) signal by the ECB that it is fully committed to the irreversibility of the euro (hence the lack of default).
The ECB will also purchase an unlimited amount of bonds. There are no clear details on the sterilization tools that can be used. The ECB will most likely soak up liquidity with its traditional weekly refi operations - as it did with the late SMP.
As widely expected, the ECB renounced to put a cap on yields. Can we try to infer a "shadow target" for local yields? Perhaps, with nominal growth, or a Taylor rule. If the euro is irreversible, then the "convertibility premium" could be a guide as well: the premium paid to holders of foreign-currency-denominated assets is relative to the rate paid in international markets. In the case of the euro zone it would be better to call it a "redenomination premium." I doubt that it will be the principal guidance of the ECB.
Yield curve reaction might be a much better indicator. Below is a chart of 2/10-year sovereign curve slopes in the euro area. Inverted yield curves are historically a clear sign of an increased default risk in the short run. Expectation of a purchase policy focused on short tenor triggered a steepening of sovereign curves in non-core countries.
The question now is: will investors search for yield and ramp up the yield curve now that there is an implicit (albeit unknown) cap on short term yields? Undoubtedly, the October 18th EU Council meeting and the decisions on Greece and, may be, the emergence of a potential candidate for external assistance, will be a significant trigger.
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