The ECB: On the Back of a Tiger
Markets are worried about the European banks and whether they can withstand a sovereign default. Markets are worried about European sovereigns and whether they can afford to provide support to their financial sectors. Markets are worried that the European Central Bank often appears to act as a reluctant fireman. However, what the market doesn't seem to be sufficiently worried about is that the path the ECB is on is not sustainable. And I believe this may become painfully evident by the end of August.
Nuances of Bond Purchases
It may be a bit nuanced, but if you stick with me here, you'll be able to observe what could very well be another accident in slow motion.
Recall that back in May, the ECB announced it would buy sovereign European bonds in the secondary market. It insisted that this was not tantamount to quantitative easing, because it would sterilize the impact on money supply. It said it was buying the sovereign bonds to help repair the transmission mechanism of monetary policy, which appeared to have broken down.
The ECB does not announce how many bonds it is buying. The market backs into it by monitoring the ECB's sterilization operation. The ECB sterilizes its bond purchases by draining an equivalent amount of euros form the system, by offering one-week fixed-term deposits. These are like the ECB's own one-week bills, though none dare call it that for risk of violating some treaty or protocol.
The ECB has been purchasing sovereign bonds for eight weeks through the first week of July. The first week it bought EUR16.5 billion of sovereign bonds and invited bids for EUR16.5 billion of the fixed-term deposits. In the second week, the ECB bought EUR10.5 billion of sovereign bonds and invited bids for EUR27 billion (16.5 + 10.5) of fixed-term deposits. The point is that the amount of fixed-term deposits the ECB offers is the sum of the sovereign bonds it has purchased.
Here is the Rub
In the last week of June, the ECB invited bids for EUR55 billion of fixed-term deposits. There were 45 banks participating, but they only had demand for EUR32 billion. The auction failed, with a 0.6 bid-to-cover ratio. Banks faced the expiry of a large 12-month refinancing operation (more than EUR440 billion) and that may have deterred participation.
In the first week in July, the ECB invited bids for EUR59 billion of fixed-term deposits. Almost 90 banks participated in the auction, which produced a bid-to-cover ratio of 1.5.
What is the problem? Well, first, the interest rate the ECB has to pay on those fixed-term deposits is creeping up. The most recent auction produced an average yield of 56bp and the failed auctioned produced an average yield of 54bp. With Euribor and euro LIBOR continuing to rise, the ECB will likely be forced to pay higher interest rates.
Euribor and euro LIBOR stand at 10-month highs. To the extent that this reflects banks' reluctance to lend to each other, it is difficult to envisage this reversing until at least after the stress-test results are published, supposedly on 23 July, and it becomes clearer how banks will raise more capital.
Second, the dysfunctional European financial system is distorting the signals from the capital markets.
For example, the difference between the December Euribor futures contract and the December Eurodollar futures contract has risen by roughly 45bp since late May. In the same period, the spread between the U.S. and the German two-year note has swung from almost 34bp in the U.S.'s favor to 6bp in Germany's favor. Shifting interest -ate considerations appear to be a factor that has helped encourage the 6% (largely) short-covering recovery in the euro.
If the higher rates are a function of the stress in the European financial system, then it seems unsustainable and a potential source of vulnerability in the euro.
More Rub
In addition to higher rates, which do not appear to have peaked yet, there is another constraint on the ECB's current course: the desire of banks to buy the fixed-term deposits. European banks, on average, have bid for about EUR82.5 billion at the weekly tenders.
In recent weeks, the ECB has slowed its bond purchases to about EUR4 billion a week. If this pace is maintained, in 5-6 weeks, the ECB will be trying to place more fixed-term deposits than the market may have appetite for. Of course, the demand may be elastic to price. The price is higher interest rates. This, in turn, would exacerbate the distortion in the money markets. Given the fiscal tightening in the pipeline, the last thing the Eurozone economy needs is higher interest rates. In Q1 2010, the Eurozone economy expanded by 0.2% on a quarter-over-quarter basis. There is little reason to expect growth to accelerate significantly. The European Commission itself forecasts growth at 0.7% for 2010.
There are many options for the ECB. It could slow the sovereign bond purchases further, or stop altogether, but that might not really solve the underlying problem. The ECB has indicated it will hold the sovereign bonds to maturity. That means that even if it were to stop new purchases, it would have to continue to sterilize the existing stock. The fixed-term deposits it is selling are like its own one-week bills.
Another alternative would be for the ECB to introduce a longer-term fixed-term deposit. The longer tenor would allow it to reduce the frequency at which it would have to go to the market. The cost would likely be even higher interest rates.
The ECB could also, at least theoretically, stop the sterilization process in full or in part. However, the ECB seems very reluctant to engage in purer quantitative easing. After being forced to reconsider his initial stance on several different issues in recent months, ECB President Jean-Claude Trichet would risk the institution's credibility. This would seem like among the least likely courses of action, therefore, barring outright and sustained deflation.
The numerous central banks that have engaged in the recent unconventional actions did so in relatively distinctive ways that fit their unique institutional framework and politico-economic culture. The ECB's unconventional policy of buying sovereign bonds and sterilizing their impact on money supply seems to not only raise questions about its exit strategy, but also suggest there might be a problem with scaling, something that was hinted at in late June, when banks did not want to purchase as many one-week IOUs as the ECB was trying to sell.
Despite the ECB's cautious nature, it is almost as if it is on the back of a tiger. And it is not clear whether it is better off being on the tiger's back or not. As the ECB continues to buy sovereign bonds, the sterilization process will become increasingly cumbersome. When it stops the purchases, it will have to continue to sterilize the stock of bond it holds, which it says will be to maturity. Imagine then what happens if a sovereign restructures its debt by extending maturities. The fixed-term deposits will no longer be a temporary convenience. They may become a semi-permanent instrument.
