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Over a number of years I had professional involvement with two-tiered markets. I’m not sure I can remember them all. Spanish A and B Pesetas come to mind. There was a two-tiered French Franc for a bit. I think Belgium had two markets as well. South Africa was two-tiered for years; Venezuela and the Philippines the same. At one point or another, all of the countries in South America were two-tiered. One of the more famous two-tiered markets was the Russian Ruble.
My interest in two-tiers was that they were (generally) exploitable. The markets had these features:
- Tier (A) was priced controlled by the central bank. There were limits on who could access this rate, and for what purpose.
- Tier (B) was not supported by the central bank, and floated freely in price; subject to supply and demand and the whims of the market.
- The price of A was always “rich”.
- B always traded very cheap relative to A.
- Liquidity for B was weak (hence exploitable).
Of course all this business of As and Bs is 25-30 years old (and long since forgotten), so you might ask why am I writing about it today?
The reason is that Mario Draghi is a few days away from creating the biggest two tiered market in history. The Arbs will make a fortune. And like all two-tiered markets, Mario’s will ultimately fail.
Draghi has hinted that his “I’ll do anything” plan was to cap yields on Spanish and Italian short-term paper. There have been recent “leaks” (bullshit – this was deliberate) that Super Mario will target the ECBs firepower to maturities of three-years and under.
I believe the leaks will prove true. Draghi is going to cap the short end for Spain and Italy. I think those caps will be generous (high caps do not get the monetary transmission Draghi wants). To have a measurable effect, the Spanish curve would have to be: 1Yr =<1%, 2Yr = <1.5%, 3Yr = < 2.0%.
If Draghi was bent on destruction, he could (temporarily) achieve these results for the Spanish bond market. In this modern example, the “A Tier” would be Spanish - < 3-year paper. The price would be controlled by the ECB; it would trade “rich” relative to the bond spreads today. It would trade very rich relative the bond yields on paper with maturities 5 years and out. There would be limitations on the Spanish Treasury on how much new paper they could issue in the three year window.
Existing bonds with maturities > 3-years would be the “B Tier”. Those bonds (and any new ones Spain tries to sell) will be tainted. There will be no promise of any price support. Long-dated paper will be functionally subordinated to shorter-term issues. This will be reflected in the price. The long-end for Spain will be sacrificed. In this environment, liquidity dries up. Spreads widen out. “Sharpies” will make bucks.
Did I mention that two-tiered markets don’t last very long? That they are a clear and present sign of economic disease? And they always end badly?
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