Submitted by Pater Tenebrarum of Acting Man [12]
The "Maturity Crunch"
Central Bank Policy Implementation and the ECB's Plan
In order to avoid the appearance that its plan to buy bonds of peripheral governments does indeed amount to 'funding of governments by the printing press', the ECB has tied the plan to the condition that it has to happen in parallel with EFSF/ESM rescues. However, that was not all – there was another stipulation mentioned by Mario Draghi during the press conference. We briefly remarked on this already in our summary and analysis of the ECB decision last week.
The other part of the plan, which is supposed to make the operation more akin to a 'monetary policy' type intervention, is to concentrate the buying on the short end of the yield curve. The thinking behind this is that in 'normal times', the central bank is mainly aiming to manipulate overnight rates in the interbank funding markets as well as other very short dated interest rates rates. Hence intervention in the short end of the curve closely resembles this 'normal' implementation of monetary policy. With this, the ECB probably also tries to differentiate its actions from those of the Fed and BoE.
Usually, the central bank determines a 'target rate' for overnight funds, and whenever credit demand wanes and interbank rates drift below this target, it is supposed drain liquidity. Whenever credit demand threatens to push interbank rates above the target rate, it will add liquidity.
During boom times, very little 'draining' tends to happen. As a rule, central bank target rates will be too low, and as speculative demand for short term credit keeps increasing during a boom, its liquidity injections – which provide banks with the reserves required to keep the credit expansion going – will aid and abet the growth in credit and money supply initiated by the commercial banks.
In the euro area, this method of overnight rate targeting has produced roughly a 130% expansion of the true money supply in the first decade of the euro's existence – about twice the money supply expansion that occurred in the US during the 'roaring twenties' (Murray Rothbard notes in 'America's Great Depression' that the US true money supply expanded by about 65% in the allegedly 'non-inflationary' boom of the 1920's).
This expansion of money and credit is the root cause of the financial and economic crisis the euro area is in now. This point cannot be stressed often enough: the crisis has nothing to do with the 'different state of economic development' or the 'different work ethic' of the countries concerned. It is solely a result of the preceding credit expansion.
Since long term interest rates are essentially the sum of the expected path of short term interest rates plus a risk and price premium, the central bank's manipulation of short term rates will usually also be reflected in long term rates.
In the euro area's periphery, the central bank has lost control over interest rates since the crisis has begun. The market these days usually expresses growing doubts about the solvency of sovereign debtors by flattening their yield curve: short term rates will tend to rise faster than long term ones. This in essence indicates that default (or a bailout application) is expected to happen in the near future. It is possible that this effect has also influenced the ECB's decision to concentrate future bond buying on the short end of the yield curve. However, as is usually the case with such interventions, there are likely to be unintended consequences.
The Rollover Problem
Recently the bond maturity profile of Italy and Spain looked as depicted in the charts below. Note that the charts are already slightly dated (this snapshot was taken at the beginning of the year), so there may have been a few changes in the meantime, but they probably still represent a reasonably good overview of the situation:
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There has been an enormous shift in the maturity schedule of the debt of both governments when we compare these charts to the situation as it looked in May of 2010, when the following snapshots were taken:
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As of mid 2010, Italy had €168.2 billion of debt coming due in 2012. At the beginning of 2012, this had increased to € 319.6 billion – a near doubling. In Spain, the change is even more extreme:
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As of mid 2010, Italy had €168.2 billion of debt coming due in 2012. At the beginning of 2012, this had increased to € 319.6 billion – a near doubling. In Spain, the change is even more extreme:
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In mid 2010, € 61.2 billion of bonds were expected to mature in 2012. At the beginning of 2012, this number had swelled to €142.2 billion.
What accounts for this enormous change? When interest rates began to rise sharply, the governments of Spain and Italy ceased to issue long term debt, opting to shorten the maturity spectrum of their debt instead. This was done because long term interest rates had become too high for their taste. It was no longer considered affordable to finance the government at these rates when they exceeded 6% and later temporarily even 7%.
Thus panic began to set in when short term interest rates began to rise sharply as well in November of 2011 and again from March 2012 onward.
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Now we can already see what the problem with the ECB's plan is: it will tend to shorten the average maturity of peripheral debt even further once it is implemented. In fact, it already has this effect even before the ECB has bought a single bond, as rates on the short end of the curve have recently fallen sharply in reaction to the announcement.
As Bloomberg reports [18]:
“European Central Bank President Mario Draghi’s bid to bring down Spanish and Italian yields may spur the nations to sell more short-dated notes, swelling the debt pile that needs refinancing in the coming years.
[…]
“In a way what the ECB has done is making the situation worse,” said Nicola Marinelli, who oversees $160 million at Glendevon King Asset Management in London. “Focusing on the short-end is very dangerous for a country because it means that every year after this they will have to roll over a much larger percentage of their debt.”
The average maturity of Italy’s debt is 6.7 years, the lowest since 2005, the debt agency said in its quarterly bulletin. The target this year is to keep that average at just below seven years, according to Maria Cannata, who heads the agency. In Spain, where the 10-year benchmark bond yields 6.94 percent, the average life is 6.3 years, the lowest since 2004, data on the Treasury’s website show.
“Driving down the short-dated yields provides a little bit of comfort and encourages Spain and Italy to issue more at the short-end,” Marc Ostwald, a strategist at Monument Securities Ltd. in London, said. “The problem is that you are building up a refinancing mountain.”
(emphasis added)
Even if the ECB buys the bonds of Italy and Spain, they will still have to repay them and regularly roll them over at maturity. By inducing them to shorten the average maturity of their debt further, the ECB creates new risks, especially as the economic downturn remains in full swing and is likely to worsen the fiscal situation of both countries in the short to medium term.
Interestingly, a similar shortening of average debt maturities can be observed in the euro area's 'core' countries. France is certainly considered a 'core' country and is currently treated as a 'safe haven' by bond investors. However, this is a tenuous situation, as it can still not be ruled out that the government will eventually be called upon to bail out the country's banks. At the moment all is quiet on that front, but it was only in November last year when the market was extremely worried about the risk these banks face in view of their enormous balance sheets and potential funding problems.
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A similar tendency to shorten the government's debt maturity profile can be oberved in Germany:
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Now, Germany and France are obviously not expected to have problems rolling over their debt in the near term. The problem is rather that all these countries compete for the same investment funds. In other words, the shortening of the average debt maturity in France and Germany indirectly puts more pressure on the periphery, as the total of debt rollovers in the euro area has become much larger than it was previously.
It is of course no wonder that the German treasury is eager to sell lots of debt maturing in two years or less: investors are currently stomaching negative yields on this debt, i.e., the actually pay Germany's government for the privilege of lending it money. This may be great for Germany's government finances, but it it not without risk either. After all, given that Germany is the euro area's 'paymaster', it has taken on a huge and ever growing amount of guarantees. What if the crisis worsens and Germany's guarantees are called in? In that case it could turn out that it was a big mistake to take on so much short term debt just because it looked extraordinarily cheap.
The ECB's bond buying plan meanwhile is going to pile on even more rollover risk.
All in all we are left to conclude that the euro area's governments have exposed themselves to additional risks that could have been easily avoided.
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The history of the ECB's now defunct 'SMP', via 'Der Spiegel'
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Interest rates in the UK: the BoE has also lost control over rates to some extent. There is a growing gap between the 'target rate' and the rates charged to various types of bank customers. Chart via Ed Conway [23].