Draghi Heads Toward Bond Purchases

ECB seen edging toward some version of Fed’s quantitative easing.

The European Central Bank is edging toward a bond-buying program that investors say could end up printing money, echoing efforts by the Federal Reserve and other central banks to fix a credit crisis nearing its sixth year.

ECB President Mario Draghi yesterday left open the question on whether the bank would neutralize future bond purchases, a step it has taken with all of its interventions to date. He also said the size of the new program would be “adequate to reach its objective” of curbing Italian and Spanish borrowing costs, a contrast with the “limited” scope of the previous approach.

“You shouldn’t assume that we will not sterilize or sterilize,” he told reporters in Frankfurt. Spanish and Italian bonds slumped as Draghi steered clear of spelling out all the full details of his plan, which is being resisted by Germany’s Bundesbank. Spain’s 10-year borrowing cost jumped 17 basis points to 7.33 percent at 8:17 a.m. London time.

“Bit by bit over the past two years, the ECB and all of the euro-region governments have been capitulating,” said Neil Williams, chief economist at Hermes Fund Management, which oversees 29.3 billion pounds ($46 billion) of assets, including government bonds. “I sense from Draghi’s comments he is inching toward QE and now trying to get other ECB members to sign that off. It seems to me inevitable.”

The Fed bought $2.3 trillion of mortgage and Treasury debt from 2008 to 2011 in two rounds of so-called quantitative easing to cap borrowing costs. The ECB has bought about 220 billion euros ($268 billion) of European government debt through the Securities Market Program it announced in May 2010, though it sterilized those purchases by taking the cash back as deposits to avoid stoking inflation, and hasn’t used the SMP since March.

Draghi said “risk premia” in the bond market “need to be addressed in a fundamental manner,” and details of the plan would be fleshed out in coming weeks in consultation with governments. “It is clear and it is known that Mr. Weidmann and the Bundesbank have their reservations about programs that buy bonds,” Draghi said, referring to Jens Weidmann, head of the German central bank.

The ECB said July 31 that it drained 211.5 billion euros in seven-day term deposits to neutralize the liquidity created by its government bond purchase program. About 72 banks submitted bids totaling 463 billion euros, up from 397.5 billion euros at a previous operation. The marginal rate on the term deposits was 0.02 percent.

“It does seem that the ECB is inching closer towards pushing the button on some version of QE, though details are still somewhat hazy,” said Craig Veysey, head of fixed income at Principal Investment Management Ltd. in London, part of Sanlam Group, which oversees $72 billion.


‘Pyrrhic Victory’

Draghi said that any bond purchases would focus on short-dated securities, leading Spanish and Italian notes to outperform. The yield difference between Spain’s two-year notes and 10-year bonds widened 17 basis points to 254 basis points, the most since May. The so-called spread between Italian two- year and 10-year securities reached 276 basis points, the most since March.

Spain’s two-year yield is 4.77 percent, down from as high as 7.15 percent on July 25, though up from a one-year average of 3.77 percent.

ECB purchases would “encourage heavier issuance at the front of the Spanish and to a lesser extent Italian curves,” said Marc Ostwald, a strategist at Monument Securities in London. That risks “exacerbating already burgeoning refinancing issues in the next couple of years, thus quite possibly a pyrrhic victory,” he wrote in a research note.

Draghi said countries would have to request help from the European Financial Stability Facility, the euro area’s temporary bailout fund, as a “necessary condition, but it’s not a sufficient condition” for help in curbing bond yields. That would produce a memorandum of understanding ensuring governments don’t shirk their economic responsibilities, according to Mohit Kumar, head of European fixed-income strategy at Deutsche Bank AG in London.

“You can definitely say the argument for not doing the Fed-style QE has weakened now,” Kumar said. “It’s all about moral hazards. The ECB was reluctant to do a Fed-style bond purchase because it’s concerned the approach will reduce pressure on troubled peripheral countries to reform. Now an MOU is required before the ECB can intervene and it’s likely to keep pressure on these countries.”


Serious Progress

The yield premium investors demand to lend to Spain rather than Germany for 10 years rose to as much as 605 basis points from 536 on Aug. 1. The average this year is 423. Italy’s 10-year yield premium to bunds jumped 54 basis points since Aug. 1 to 510.

“Whatever the short-term gut reaction of markets, the ECB announcement constitutes serious progress,” Holger Schmieding, the chief economist at Berenberg Bank in London, wrote in research note. “The ECB explicitly vowed to do what it takes to achieve its target and suggested that it may not sterilize the liquidity injection. In a way, this is a cross of outright quantitative easing and the successful announcement of the Swiss National Bank to do everything to defend a cap for the Swiss franc exchange rate.”


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