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The Unintended 'Chronic' Consequence Of ECB Bond Buying

Tyler Durden's picture




 

We destroyed the myth that the LTRO would not in fact stigmatize bank balance sheets when it was first introduced as the encumbrance was evident from the start - though took the market a while to comprehend and reprice (exuberant on the new-found liquidity optics). The expectations that the ECB will embark on a new scheme of sovereign debt purchases, implicitly funding governments - no matter how many times they tell us that it is to ensure transmission mechanisms flow, have three objectives or rationales, according to Goldman's Huw Pill: Easing private financing conditions through monetary expansion, Financing governments, and/or Reactivating private markets. However, there is one glaring unintended consequence of this 'aid' - the risk exists that well-intentioned sovereign debt purchases result in perverse incentives and a perpetuation of chronic fiscal and structural problems (much as Bernanke's band-aids have eased the fiscal pressure on our own government and led us further down the rabbit hole). The lack of political legitimacy and blunting of incentives for more fundamental consolidation and reform to take place can only turn the acute pain of the moment in Spain into a truly chronic problem for Europe as a whole - be careful what you wish for.

 

Goldman Sachs: Three Rationales For Sovereign Debt Purchases

We expect the ECB to announce a new scheme of sovereign debt purchases aimed at reactivating and reintegrating Euro financial markets to ensure monetary policy transmission. We compare this rationale with other motivations for central bank purchases of government debt. In the end, purchases will serve several ends. The risk exists that well-intentioned sovereign debt purchases result in perverse incentives and a perpetuation of chronic fiscal and structural problems. Guarding against this risk, while still offering meaningful support to peripheral sovereigns, remains an important challenge for ECB policies.

Attention remains focused on the ECB’s September Governing Council meeting. In August, the ECB announced that it would recommence sovereign debt purchases, so as to contain ‘convertibility risk’ (i.e., the risk of a Euro break-up and/or exit). But the modalities of how these interventions will be implemented remain under discussion. The operational specifics are controversial, as recent comments by ECB policy makers demonstrate.

Last week, we outlined our expectations of what the ECB will announce next Thursday. In short, for countries that have made a request for EFSF / ESM assistance and accepted the implied conditionality, we expect the ECB Governing Council to:

  • Show preparedness to intervene at the short end of the sovereign yield curve in an opportunistic manner so as to contain spikes in short-dated peripheral government yields, pre-empting the periodic market seizures that have been associated with such spikes in the past;
  • But eschew ‘hard’ caps on yields or spreads and/or mechanical ex ante intervention rules that would limit the operational flexibility of the ECB to choose the magnitude and timing of specific interventions.

Rationales for central bank sovereign debt purchases. When assessing such mechanisms, it is valuable to consider the objective of the bond purchase scheme. Here, comparisons with the experience of other central banks can be informative.

We identify three rationales for such purchases, noting that they need not be mutually exclusive. Indeed, by their nature, central bank purchases of sovereign debt will have implications across all three dimensions.

  1. Easing private financing conditions through monetary expansion. The quantitative easing (QE) programmes undertaken by the Federal Reserve and the Bank of England have aimed at easing financial conditions. Most narratives have emphasised the role played by portfolio balance effects. By making money-financed purchases of sovereign debt from the market, these central banks have shortened the average duration of private balance sheets. As private investors attempt to rebalance their portfolios in response, they buy longer-dated assets to increase the duration of their holdings, thereby driving up the price of equities and bonds. This leads to lower financing costs for borrowers. Such mechanisms allow monetary policy to ease financing conditions even once the lower bound on nominal interest rates has been reached.
  2. Financing governments. Central bank purchases of sovereign debt in the primary market constitute direct monetary financing of governments. Given concerns about the inflationary impact of such purchases – amply demonstrated by history, with the Weimar experience weighing heavily on German attitudes – they are prohibited by the Lisbon Treaty (the relevant clause – Art. 123 – is applicable both to the ECB and to other EU central banks, including the Bank of England) and many other central bank laws. Purchases in the secondary market can also support government financing, for example by suppressing sovereign yields. In the limit, secondary market purchases can be functionally equivalent to primary purchases, if an intermediary simply stands between the sovereign issuer and the central bank purchaser to circumvent any prohibition on primary market purchases.
  3. Reactivating private markets. Finally, central bank purchases can be used to reactivate markets that have seized up on account of information or coordination problems. For example, should a sovereign with a fundamentally sound fiscal position face a market sceptical of its solvency or commitment to the Euro, borrowing rates will rise as a credit and/or convertibility risk premium becomes embedded in government yields. But that rise in yields, by its nature, increases sovereign funding costs and could validate concerns about fiscal sustainability and/or Euro exit. The government may be trapped in a high interest rate / high default risk equilibrium, even though another, more desirable low interest rate / low default risk equilibrium exists. Well-designed interventions by the central bank can shift the market to the more desirable situation. Since the main concern is rolling over outstanding debt at sustainable rates, interventions at the short end of the maturity spectrum may suffice. And – since sovereign markets are integral to the functioning of the broader financial system – such actions can yield significant broader external benefits in terms of improving the functioning of financial markets and institutions.

 

The ECB’s approach has focused on market functioning ... The ECB has motivated its prospective sovereign debt purchases under the lattermost of these three rationales.

  • Given the Treaty’s prohibitions, an explicit attempt to finance peripheral governments would trigger legal challenges and undermine the ECB’s hard won credibility;
  • And the need for explicit QE in the Euro area is seen as more limited than in the US or UK: first, the ECB still has scope to lower its policy interest rates and so can ease monetary policy through more conventional means; and second, the Euro financial sector is already awash with excess liquidity as a result of the large 3-year LTRO operations conducted last December and February.

Mr. Draghi has correctly identified the segmentation and dysfunctionality of Euro financial markets as an impediment to the transmission of the single monetary policy, which needs to be overcome if monetary union is to be workable. The measures we expect to be announced next week – which can be characterised as an attempt to promote the reactivation and reintegration of sovereign markets – will act in this direction.

While necessary, these measures alone are unlikely to be sufficient. Funding problems for peripheral sovereigns undermine their domestic bank systems and hinder credit supply. As we have argued previously, to improve monetary transmission and ensure monetary stimulus reaches its target – notably, the peripheral private sector – additional, more targeted credit easing measures (e.g., further widening of collateral eligibility, lowering of haircuts and purchases of private sector assets) may be required.

...but the other rationales may (soon) come into play ... We would not rule out that the ECB eventually implements QE-style measures, should ECB interest rates reach their lower bound and the macroeconomic outlook deteriorate further. An emergence of deflationary risks would make such actions wholly consistent with the ECB’s mandate.

But the efficacy of such measures is open to question. Excess liquidity at present accumulates in the core countries, easing financing conditions via the portfolio balance channel in Germany where such stimulus is little needed. At the same time, market segmentation means that this easing has little impact on the periphery:

German investors with excess liquidity remain reluctant to purchase Spanish or Italian bonds, thereby leaving peripheral yields at elevated levels while German yields fall to historical lows. Reintegrating markets is a precondition for monetary policy transmission, whether for conventional actions (i.e., interest rate changes) or unconventional actions (such as QE).

...which, although perhaps inevitable, comes with attendant risks. Financing governments explicitly will run into immediate legal and institutional barriers. But, under the cover of supporting market functioning, scope also exists for central bank purchases of government debt to support sovereign funding.

Indeed, it must do so. For all the protestations of the Federal Reserve and Bank of England that QE measures are wholly monetary in nature, they have eased the funding of the US and UK Treasuries. By the same token, ECB purchases of peripheral sovereign debt will help finance peripheral governments.

Such support may be necessary and inevitable. The resources of the EFSF / ESM have long been seen as insufficient to meet the financing needs of Spain and/or Italy in a credible way. Mobilising the ECB balance sheet in parallel with EFSF / ESM actions provides capacity for the necessary volume of purchases, while maintaining the conditionality that was absent from the ECB’s previous securities markets programme (SMP). Taking a sympathetic view, the envisaged ECB measures can be seen as a proactive attempt to create a framework that allows such financial support to be offered to peripheral governments in a structured and limited manner.

But such measures come with risks. Both the strength and the weakness of central bank financing will soon become apparent. As a flexible and immediately available source of sovereign funding, central bank financing is a powerful tool to deal with crisis situations. But it lacks political legitimacy and can blunt the incentives for more fundamental consolidation and reform to take place, helping to transform a crisis into a chronic problem.

 

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Thu, 08/30/2012 - 09:35 | 2749234 Abraxas
Abraxas's picture

Why would anybody buy somebody else's debt?

Thu, 08/30/2012 - 09:40 | 2749246 GetZeeGold
GetZeeGold's picture

 

 

I know this.....because they have too?

 

Thu, 08/30/2012 - 09:42 | 2749247 MillionDollarBonus_
MillionDollarBonus_'s picture

Long term peripheral debt is a winner's trade. Just look at these mouth watering yields! Where else can you get frequently compounded cash flows, low risk provided by an accommodative ECB and European commission, and potentially huge capital gains in the event of an emergency financing? This is just an incredible investment. I just can't emphasize enough how much doomer ZH investors are missing out here ...

Thu, 08/30/2012 - 09:50 | 2749277 Stackers
Stackers's picture

coin op self serve car washes and laundromats offer compounding cash flows too.

Thu, 08/30/2012 - 09:58 | 2749302 Mugatu
Mugatu's picture

The EU has done such a wonderful job handling all the past sovereign issues - haven't they? 

Never bet on anyone or anything that has a track record of incompetence and stupidity.

Thu, 08/30/2012 - 11:03 | 2749516 MillionDollarBogus_
MillionDollarBogus_'s picture

This talk about high yield sovereign debt being a problem is just silly.

Monty will print, the high yield bonds will be repaid 100%.

I sold my physical PM's and am putting everything into short term Greek paper.

Can't lose on this bet.

Who's with me..??

Thu, 08/30/2012 - 11:22 | 2749581 Stackers
Stackers's picture

Nobody who signed the Maastricht Treaty

Thu, 08/30/2012 - 09:35 | 2749235 molecool
molecool's picture

Pure mental masturbation.

Thu, 08/30/2012 - 10:19 | 2749372 fuu
fuu's picture

It's Goldman.

Thu, 08/30/2012 - 09:36 | 2749236 GolfHatesMe
GolfHatesMe's picture

Somebody needs to be hitting the Chronic

Thu, 08/30/2012 - 09:41 | 2749251 diogeneslaertius
diogeneslaertius's picture
Unintended?
Thu, 08/30/2012 - 09:42 | 2749255 g speed
g speed's picture

OH OH --printing has risk!!  yawn--snore

Thu, 08/30/2012 - 11:55 | 2749640 slewie the pi-rat
slewie the pi-rat's picture

almost all the posts today are addressing basic issues covered here months ago

b/c of all the trolling, lying and political and bankstereng misinformation published here since we went "chat room ready"  to war in GROUPS of bots or the few other actual persons here who readiliy gave up their anonymity for "new friends", tyler may have, as i've been trying to point out to others for a long time here now, a c.r.e.d. problem

se he hasta try to re-establish his cred on the way to the bank this morning

ther's another article explaining the ltro and the EU "jumping over its own knees" fiscal problem too!  trying to re-establish some meaning for himself here after after becoming one of the most heinous douchebags of propaganda vomit in interwebs history

b/c of the typhoon in theGulf, one of his prop-agents didn't get the memo that the schedule had been changed and published the "evilFED" hit-piece without the political action with which it was s'posed to dove-tail

and i just steam-rolled them both for using zH as a toilet for mittens

speaking of trolls and asswipe propagandist, this is where million$cunt's post would be if he hadn't jumperd the string again (or tried to--somebody hit "save" before he did there, see it?) for his formulaic "joke" vomit

to tell us about "printing" so over-simplistically again and feed the people who can't think straight here (about 75% of the humansl 92% of the total  'bloggers')

in fairness to mil$cuntster, he did reply to someone about a week or so ago and it was quite intelligent;  everybody wondered wtf was going on here, too

he stepped out of character and slewie would say that the people who pay him to fuk up our work here below the line were very displeased b/c they took him down for a while and he didn't get paid while down, propably, did he?

so now he is back to "innocent" and again, only 1-2 people understand the actual REAL dynamics here

so the efforts to re-establish c.r.e.d. are well underway here and i applaud THAT

unfortunately, the rupublicunts are doomed and may not be given control of the USA for many elections to come

when your last 4 'winners' consist of nixon1, reagan2, CIA bushI3, and skell&bones harvard ignoramus bushII4 and theParty shit-canned rPaul for neoCon mittens whose career was also launched by drug-goonie money from central/south america, you are now unelectable

the fact that the criminals running the GOP (or can't one figure where "lindaGreen" was created and why?) are just thugs and not smart enuf to win at this point probably makes their "convention" a bit less that "bubbly"

but they were strong enuf to take rPaul down while he was "serving" them (and tyler) with gobs of money when people see nixon, reagan bush & bush, and a solvent and our strong nation go totally BK in 5 years of "war on terror" under them,  even americans might say:  what's that?  coffee?

perhaps even tyler and the other mindless republicunt trolls here are now "getting" that their precious mittens in unelectable

the party of rockefeller is the party of the manchurian candidates, ya know;  nixon DID go kiss mao's ass to get jMcCain out the hanoiHilton;  reagan went propwash on rusiia, NOT china, and under bush I & II america was economically gutted and her military put under the control of the NWO, as well as our CFR

and the bankster may have been given a "pass" b/c they all have "diplomatic immunity" as agents of our debt-holders;  or did you conclude they were working for "american interests" and just "made a mistake"

now i won't stick up for billClinton as an apologist for the WTO;  he marginalized ALL the intelligent young people who knew in their hearts and guts it was a sell-out and gave china "favored nation status" in 96 (just in case he didn't "win" 5 months later

by jCarville hit the "economy styooopid" theme and get him back in there, didn't he?

in fairness to the repubs, the Ds are so "nannified" they just don't "get it"

however if they are gonna govern or try to, for the next 4 years, i think the citizenism might see the danger of losing OUR sovereignty to DEBT

this is why greece hasn't been slammed isn't it?  the NWO wants to wait till after november before nation of TV-controlled "goodies" is shown theRealityShow on that one!

it will be "Pay or Consequences" 

but america has already been BK'd under bushII, hasn't it?  the capital structure and what's left of the economic engine has been "bailed out" by putting it all into the NWO holding company and annuitizing it.  can you say "manchurian candidates" or can't that be true either b/c the TV doesn't "know" it?

but unless ya turn off yer TV you will not be "able" to see it, b/c the MSM doesn't want you to see it;  neither does million$cunt, btw, you moronic shitheaded asswipes!

anyone with the most rudimentary understanding of the geopolitics of the vietNam (2nd indo-china war) knows that the mekongDelta is the "breadbaskets" of the north and of chin, too;  kennedy went after it, hard, and was taken out, as were both his brothers, one with a gun, another with a dead woman and a narrow bridge on matha'sVineyard

and now the US breadbasket is under the control of the internationalists, also, thru corpo-fascist organization and the "tax codes"

food is pretty important economically;  even debt-slaves hafta eat;  but the constant propaganda about OIL (and tyler is certainly not unique in pandering to this illusion) mans the TV doesn't hafta even mention the politics/economics of food which (golly) just "happens" to be about the only "markets" with any real action which i try to advise people of continually, btw

go ahead and take a nap if you wish;  tyler has to get back to basics now and see if he has a site and ANY cred salvageable'  i think it does

but is fightClub really for our tyler?  or is it just a "theme" which the spooks dreamed up for him to play offa?  and us too.  of course

Thu, 08/30/2012 - 12:36 | 2749834 shovelhead
shovelhead's picture

Is your inner rat snorting D-Con again?

Thu, 08/30/2012 - 09:43 | 2749256 ShorTed
ShorTed's picture

Go figure, Goldman supporting the idea of a Goldman alumni doing a bail out.

Thu, 08/30/2012 - 09:54 | 2749289 No Euros please...
No Euros please we're British's picture

Hey Mario, I think you just received your orders from the muppet master.

Thu, 08/30/2012 - 09:47 | 2749262 Hayek FA
Hayek FA's picture

This shit is tired- Drop rates to -10% and get central banks to buy anything that has ink on it.  May as well get it done.

Thu, 08/30/2012 - 09:46 | 2749267 icanhasbailout
icanhasbailout's picture

Chronic consequences? Blunting of incentives?

 

pass the Duchie and don't Bogart that joint

Thu, 08/30/2012 - 09:51 | 2749282 diogeneslaertius
diogeneslaertius's picture

pass the dutchie on the left-hand side (selah)

Thu, 08/30/2012 - 09:49 | 2749279 diogeneslaertius
diogeneslaertius's picture

put the entire world's leg in an economic bear trap then throw world war three at them, people will beg for a new world order

 

people will beg for waterloo 2.0, "go ahead buy it all up for pennies on the fiat instrument you created to cause the chaos, we dont care, we will go into further bondage, heck we are already in bondage, just end the chaos"

 

and when the enemy understands incrementalism this well - one must b on one;s guard not against immediate crises, but rather protracted debasement itself - both of the culture and the fundamentals

 

 

 

in a rigged game the onlky way to win is to not play; however... alas, for man is the eternal chess playe, in it for the game and not the resultant.

thus, the only way to win a rigged game is to Invent a New Game, even if its small and only afew people are playing it

Thu, 08/30/2012 - 10:03 | 2749325 covert
Thu, 08/30/2012 - 09:56 | 2749295 SoundMoney45
SoundMoney45's picture

5000 years of monetary history tells us that fiat currencies with fraction reserve banking always ends the same way.  Human nature has not changed, and it will not be different this time.

Thu, 08/30/2012 - 10:01 | 2749315 Hedgetard55
Hedgetard55's picture

"

  1. Financing governments. Central bank purchases of sovereign debt in the primary market constitute direct monetary financing of governments. Given concerns about the inflationary impact of such purchases – amply demonstrated by history, with the Weimar experience weighing heavily on German attitudes – they are prohibited by the Lisbon Treaty (the relevant clause – Art. 123 – is applicable both to the ECB and to other EU central banks, including the Bank of England) and many other central bank laws. Purchases in the secondary market can also support government financing, for example by suppressing sovereign yields. In the limit, secondary market purchases can be functionally equivalent to primary purchases, if an intermediary simply stands between the sovereign issuer and the central bank purchaser to circumvent any prohibition on primary market purchases."

     All I can say is holy shit, do they even understand what this means? This is the same shit Ben has been pulling, and the vig goes to the banks. This is why he can claim he has not monetized the debt, when he has.

Thu, 08/30/2012 - 10:23 | 2749389 wagthetails
wagthetails's picture

We need continued analysis on this. we'll have to be armed with this knowledge for when the US Gov starts bailing out/or buying debt of bankrupt states.  Sadly, we will probably be dealing with the US version of alphabet soup fancy acronyms. 

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