This content is from: Portfolio

Markets React Well, but Draghi Debt Plan Is Just the First Step

ECB President Mario Draghi has successfully tackled the symptoms of Europe’s debt crisis. The causes, however, remain.

European Central Bank President Mario Draghi successfully calmed the markets with the promise of unlimited purchases of euro zone sovereign bonds. But the new Outright Monetary Transactions, as they are known, will only buy time, like the €1 trillion long-term refinancing operations of December and February, rather than resolve the euro zone debt crisis in themselves. With the euro zone economy forecast by the ECB to contract by between 0.6 percent and 0.2 percent in 2012, the real battles ahead will be fiscal.

Draghi on September 6 said the OMTs would allow the central bank “to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors that the euro is reversible.” Bond purchases would ensure “price stability,” he said, and pledged the ECB would provide “an effective backstop” to the euro.

Expectations had been high after Draghi had pledged on July 26 to do whatever it would take to preserve the euro, and he did not disappoint. “Draghi ticked off all the items on investors’ shopping lists,” says Nick Gartside, international chief investment officer in fixed income at J.P. Morgan Asset Management in London. “He showed the ECB has a very powerful toolkit.”

Even though Draghi stressed there would be conditions attached to the OMTs and that the ECB would concentrate on buying bonds with maturity of between one and three years, even the yield on Spanish 10-year bonds fell sharply. On September 6 it fell 38 basis points to 6.03 percent and on the morning of September 7 it was down to 5.73 percent. As recently as July 24, the yield had been a dangerously high 7.62 percent as the markets feared Spain would struggle to cope with its debt amid a worsening recession. On the morning of September 6, amid optimism before Draghi’s announcement, Spain had managed to sell €3.5 billion worth of 2- to 4-year bonds at sharply reduced yields. It sold €1.4 billion of four-year bonds at an average yield of 4.6 percent, down from 6 percent a month earlier.

“This could be a real game changer in bringing down bond yields. But there’s no quick fix: it’s still a bumpy road ahead with event risks,” says Cossimo Marasciulo, head of European government bonds and FX at Pioneer Investments in Dublin.

Marascuilo, whose team manages €25 billion in fixed income assets, adds, “I don’t think any conditions are likely to be very tough as Spain and Italy are already doing a great deal to improve their fiscal positions. As investors we are long on Spain and Italy and underweight in bunds.”

The OMTs require governments to appeal for assistance through the rescue fund the European Financial Stability Facility or its successor the European Stability Mechanism. Crucially, however, they would not have to apply for full bail-outs or “macro-economic adjustment programmes”. A more limited “precautionary programme” would be enough. But, even though the markets seem to be anticipating ECB support for Spanish bonds, according to Investec Bank’s London-based chief economist Philip Shaw, “it’s not a cast-iron certainty Spain will ask for assistance.” Spain, under Prime Minister Mariano Rajoy, has strongly resisted a full bail-out and the country is already in line for €100 billion of EFSF assistance for its banks.

Andrew Bosomworth, a Munich-based managing director and head of portfolio management in Germany for Pimco, says Draghi has probably bought the euro zone another three years during which it must resolve its problems. “I can see investors returning to euro zone sovereign bonds,” he says. Bosomworth, who was a senior economist at the European Central Bank in the 1990s, warns, however, that “the OMTs tackle the symptoms rather than the cause of the debt crisis. Draghi is taking a leap of faith that the euro zone can make fiscal progress. Governments have to cut their deficits and the euro zone has to move towards fiscal union.” Investec’s Shaw also says, “The OMTs in themselves can’t be the sole response to the debt crisis — fiscal positions need to be improved and there has to be a degree of economic growth.”

For the moment, full marks have to be awarded to Draghi, especially as he has successfully outmaneuvered the Bundesbank which has always made plain its opposition to sovereign bond purchases on the grounds that the ECB should not finance governments. “Merkel is supporting Draghi, so the Bundesbank is marginalized,” says Bosomworth. During his press conference on September 6, the ECB President said one member of the ECB Council had opposed the OMTs, without naming him. Jens Weidmann, Bundesbank President, was not slow to declare himself, issuing a statement that admitted he was the dissenting member.

Related Content