- The ECB has started to buy Italian and Spanish government bonds, showing off what some have called the central bank’s ‘bazooka’. The question is why the markets have not been more impressed.
- The single biggest reason for the lack of enthusiasm in the market may be the relatively small size of the interventions so far, particularly when compared with the initial purchases of peripheral countries last year.
- The ECB may want to drive home the point that governments in the affected countries have to take further fiscal and structural measures in order to receive more support.
- For the euro, today’s limited ECB action will keep life difficult, particularly against the Swiss franc. The SNB may soon be forced to intervene if it wants to avoid credibility losses on the back of last week’s strong words.
If a few weeks ago anybody would have suggested that the ECB would soon be buying Italian and Spanish government bonds, most people’s reaction would have been one of disbelief. Yet last night the ECB indicated exactly that, and put it into practice this morning. So why have markets not reacted more strongly to what observers have called the central bank’s ‘bazooka’?
1) The single biggest reason for the lack of enthusiasm is certainly the limited size. When the ECB launched its Securities Markets Programme (SMP) in May 2010, it bought €16.5bn of Greece, Ireland and Portugal in the first few days, and €40bn in the first month. In contrast, today’s purchases have amounted to an estimated €1-2bn, an almost negligibly small amount for the much larger markets of Italy and Spain.
2) Markets remain sceptical as to the determination of the ECB in view of the reported Bundesbank opposition. The question is whether President Trichet would really be willing to push through large scale bond buying against the resistance of the Bundesbank and possibly others too. The German government may have indicated that it supports the ECB expansion of the SMP, but as long as the Bundesbank is opposed, things will remain difficult.
3) The implications of the ECB intervening on the Italian bond market, the third largest globally, are manifold and complex, including the fear of debt monetisation. The ECB will certainly claim that any SMP activities will continue to be fully sterilised and hence cannot be viewed as quantitative easing (QE). However, while the around €76bn current size of the SMP may be relatively easily sterilised, this may be more difficult with substantially larger amounts (even though as long as the ECB offer unlimited cash to banks this may be a moot point).
Quid Pro Quo
Why has the ECB been buying Italy and Spain relatively timidly today, in an arguably largely symbolic fashion? The most likely reason is that the ECB wants to give a signal to Spain and Italy that while it is ready and willing to help, any further, larger scale support would require additional fiscal and structural measures. Last week’s actions by the Berlusconi government were welcomed in last night’s statement, but Germany in particular may want to see further measures and let the ECB drive the point home more forcefully. The general view is now that the ECB is willing to reward countries that are doing ‘the right thing’, and even though Spain and Italy seem on the right path, the potential for further measures is certainly still large. So the ball may be back in the politicians court, which is not necessarily a comforting thought for the markets.
SNB action required
The euro has been volatile, but essentially flat against the dollar over recent weeks, if not months. Most of the action seems to have been against the Swiss franc, where further all time lows are once again within sight. The SNB statement last week was a very aggressive one, calling the franc ‘massively overvalued’, and was followed up by arguably even stronger language last Friday, when President Hildebrand called current franc levels ‘absurd’. We have argued that these comments suggest that further action will be taken should the franc strengthen further or even just fail to react to the SNB’s liquidity measures (see FX Comment: CHF und SNB pressure, 3 August). This situation has arguably now occurred with EURCHF once again trading below 1.08. However, while we previously argued that the next steps to contain further appreciation may contain be administrative measures, it now seems that outright FX intervention may be more likely. The reason is that any administrative measures may require some level of cooperation with the government, which would likely take some more time while the situation is calling for urgency. Note that there is an ‘extraordinary’ meeting of the Federal Council later today, but this had been scheduled for some time and franc strength is not the main item on the agenda. Hence, it would seem that little should be expected from this meeting, meaning that any quick action would have to come from the SNB.
Conclusion
The ECB has taken a stunning decision by starting to expand the SMP to Italy and Spain. However, the market has been less than impressed, mostly due to the relatively small scale of the interventions. The euro was initially supported, both against the dollar and the franc, but the impact quickly faded. The ECB is giving the impression that it has been acting reluctantly and with less than full conviction, which the market is sensing and acting accordingly. It may be that the ECB is now waiting for further measures from the Italian and Spanish governments, or progress on the EFSF ratification process, before increasing its SMP activities, which is not a comforting thought for the markets.
For the euro, the above means that life will remain difficult. Against the dollar, tomorrow’s FOMC meeting will play a crucial role, with wide expectations of Bernanke at least hinting at the possibility of QE3. Should these hints not be forthcoming, maybe because inflation readings have been firming up recently and payrolls better than expected last Friday, then EURUSD could quickly drop below 1.40. Against the Swiss franc, it seemingly all depends on the SNB now. Any hint of QE3 would probably quickly drive the franc stronger, while any dollar strength due to Bernanke failing to mention QE3 may not have much impact on EURCHF. Hence, it would seem that in both cases a drop to 1.05 looks entirely possible, requiring an SNB response in order to avoid credibility losses given the very strong statements last week.
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Beat Siegenthaler
UBS Investment Bank
FX Strategy