Wednesday, 08 July, 2015
Three years ago, eurozone bond markets almost ripped Europe’s monetary union apart. Not this time.
Even as the risks of Greece being thrown out of the eurozone have escalated, bond market reaction has remained tame.
One explanation is that investors have had time to prepare for a possible “Grexit”, and believe “contagion” risks for the rest of the eurozone would be manageable.
Another — arguably stronger — reason is investors’ faith in the European Central Bank and the powerful effects of its €60bn-a-month asset purchases under eurozone quantitative easing, launched in March.
“Markets’ trust and confidence in the ECB firewall — which has proved absolutely credible before — explains the spectacularly muted reaction to rising ‘Greek event’ risks,” says Peter Goves, fixed-income strategist at Citigroup.
Gilles Moec, European economist at Bank of America Merrill Lynch, says: “The ECB has gained massively in credibility since it actually started QE.”
Whether the ECB can maintain its control over bond markets will be vital for eurozone leaders as well as investors. Back in July 2012, when the eurozone crisis was at its most intense, Mario Draghi, president, eventually promised “whatever it takes” to preserve the monetary union’s integrity. The risk this time is that its interests clash: that restrictions imposed on Greek banks push the country toward Grexit, creating instability across the eurozone.
But markets have taken reassurance from ECB policy makers’ hints they could expand their armoury to limit financial market fallout. “The perception, at least, is that the ECB will act if necessary to ensure there are no big dislocations in the rest of the eurozone,” says Nick Gartside, chief investment officer for fixed income at JPMorgan Asset Management. “One thing we have learnt is never to doubt the creativity of the central bank.”
Despite the political dramas, yields on government bonds of southern European “periphery” countries — Italy, Spain and Portugal — have risen only modestly. In early Tuesday trading, Italian and Spanish ten-year yields remained below last week’s peaks. That implies investors are not demanding an additional “risk” premium to compensate for “contagion risks” after Sunday’s Greek No vote rejecting international creditors’ reform proposals.
Keeping downward pressure on yields, which move inversely with prices, will be supply factors. Eurozone government bond issuance is expected to be negative in July: governments will pay back more to investors than they issue in new debt. Liquidity constraints might also help. Expecting thin conditions in the summer months, the ECB said it would “front-load” QE purchases in May and June. In fact, it “front-loaded” less than expected. Data on Monday showed it bought €63.2bn in assets in June, after €63.1bn in May. That could mean the ECB will bid aggressively for eurozone bonds in coming weeks.
What if that is not enough? In 2012, words worked central bank magic. Mr Draghi’s “whatever it takes” pledge calmed markets without the ECB spending a cent.
ECB policy makers’ recent comments have acted like dog-whistles in controlling bond markets. Last week, Benoît Cœuré, executive board member, told Les Echos the ECB was “even ready to use new instruments within our mandate”. Late on Monday, as it tightened pressure on Greek banks following Sunday’s referendum, the ECB reassured that it was “closely monitoring the situation in financial markets” and possible risks to price stability in the eurozone.
What caught some investors’ eyes was the ECB’s reference to “risks to price stability”. That suggested Mr Draghi could take action under the guise of bringing eurozone inflation back up to its “below but close” to 2 per cent target range — which even conservative hardliners on its governing council would find hard to oppose.
Rises in benchmark eurozone borrowing costs have not yet been sufficient to threaten the ECB’s monetary policy objectives. “The ECB certainly stands ready to act, but yields are clearly not at levels where you would say that they have to do something,” reckons Laurence Mutkin, global rates strategist at BNP Paribas.
However, that could quickly change if negotiations between Greece and its international creditors collapsed and Grexit loomed even larger. Higher interest rates resulting from higher “risk premiums” demanded by investors would amount to what the ECB would see as an unwanted tightening of monetary policy.
Since 2012, the ECB has created the instrument of “outright monetary transactions” — special bond-buying programmes to ensure the eurozone’s “singleness”. OMTs require governments to have agreed reform programmes in place, which means their use would probably be a last resort.
But earlier steps the ECB could take include implementing more aggressively its existing QE programme, for instance by stepping up monthly purchases or making clear it would be extended beyond its scheduled end in September 2016. The ECB has already expanded the list of institutions whose assets it can buy under QE. A next move might be to include corporate bonds.
Some believe the ECB might not be far from taking such steps. ECB forecasts for annual inflation to rise back within its target range in 2017 already look ambitious, argues Mr Moec. If eurozone bond yields rose and Grexit risks threatened market confidence, “then action would certainly be justified in terms of monetary policy”.
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