Monday, 20 August 2012

Rate Cap Holiday tale

While most market participants are still on Vacances, the week starting after the assumption of the Virgin signals the beginning of the end. Policy makers and traders trickle back to their desks with great holiday stories. This one from Spiegel is no different.
It is not the first time that the idea of a rate cap was floated. The story had made the rounds back in 2011 and it never really died. So what is the idea?
In essence, the ECB is going to set certain spreads over the German bund as intervention buying limits. In other words if the yields of say the Spanish 10Y bond go above bunds+500bp (say) then the ECB with its infinite balance sheet would come in and start buying forcing the yield down.

Tempting as it is to believe that this is a good way out of the debt crisis there are some rough edges in the implementation of this strategy:
  • The ECB’s balance sheet is not infinite
  • The ECB’s mandate is inflation and financial stability
  • The ECB’s governing council would have difficulty sanctioning such a policy. Especially the German influenced members
  • Capping rates pushes the market up to this rate no matter where they are now.
  • If the ECB declares this to be officially monetary policy then we have de-facto subordination of all the rest of the bond holders.
  • Commencing such a policy would have to be accompanied with some very strict conditionality imposed by the EC to the respective countries.
Here is why:
  • Although the ECB balance sheet is unlimited when it comes to the Repo transactions this is not the case in buying securities outright. The ECB started buying government bonds back in 2010. In order to justify this policy aberration it had to simultaneously implement a sterilization policy. Namely it had to withdraw the liquidity it was throwing using a regular deposit. Thus the famous Securities Markets Program (SMP) was baptised a monetary policy instrument. It is because of this that the ECB refused to take part in the Greek restructuring thus creating effective subordination in the Greek bond market.
  • Draghi sought to readjust what monetary policy means when few weeks ago he claimed that if there is a risk of “convertibility” (fancy word for exiting the euro and redenominating in a new currency) then it becomes a monetary policy issue and he can do as he pleases. I don’t think we are close to this at least for Spain or Italy. Greece is another story and there are very few Greek bonds trading anyway.
  • This is not a decision that can be taken easily even within the ECB governing council. It is very likely that northern European countries would fight such a policy shift.
  • Technically speaking such an announcement would drive the market immediately to this level and would glue the market there. In other words, it is a market destroying measure. Huge quantities of bonds would be removed from circulation as the ECB never sells back the bonds it buys. Liquidity would be reduced driving prices down and hence forcing the ECB to buy more. This is not what I call a virtuous circle; it is a runaway process to shutting the market down.
  • If this becomes official policy instrument then subordination is more than guaranteed.
  • A rate cap policy cannot be effective on its own. It must part of some much bigger scheme or plan that aims to halt the breakup of the Euro. Hence there must be some strict conditionality and countries would have to ask formally for help.

In conclusion, capping the yield is not a policy that can be done easily. But do not despair. It does not mean that it cannot be done by proxy. For example, the ECB can ask the local banks to keep on buying their country’s debt and repo this with the ECB. This is much more effective, especially now that Spanish banks would become partly owned by Europe.
Or the ECB can for the sake of transparency place a limit of few hundred billion worth of bonds that they are going to buy in the future. That limit for sure would be increased time and time again.