OK, the data are deteriorating and Europe, at the least, has reminded us of what I used to know but seemed to have forgotten: the crisis proceeds in waves as reluctant politicians and officials do just enough to survive each wave, and this is likely to continue until the final resolution — either unlimited purchases of sovereign bonds by the ECB or some kind of debt mutualisation/fiscal union. Is the latest wave still falling, as things continue to improve after the Greek election? Or is the next one rising, as the Spanish economy continues to deteriorate and Greece returns to the agenda? I tend to think that it is probably the latter.

So, are central banks going to head off the increasingly negative trend? As I argued last week, I don’t think the Fed will do so — based on its past behaviour (admittedly a small sample), the environment is not yet bad enough for QE3. What about the ECB, after Mario Draghi’s comments last week?

Today’s newsflow has a little more information about what Mr. Draghi is doing. Bloomberg reports that he is working towards a combined solution whereby the EFSF/ESM make sovereign bond purchases in the primary market, and the ECB makes them in the secondary market. Let us assume that that is actually what Mr. Draghi is trying to achieve. There is much discussion about whether the Bundesbank can be brought on board, but Mr. Draghi does not actually need its support (it doesn’t have a de jure veto on the Governing Council, after all). But he does need the support of governments, and in particular the German government, and there seems as yet to be no indication that he will get it. Referring to the idea that the EFSF/ESM could buy sovereign bonds, the German finance minister Mr. Schauble told Welt am Sonntag: “There’s nothing in it.”

What could the ECB do alone? Within the constraints of its understanding of its own role, it can lend to banks, and it can buy government bonds in the secondary market in order to maintain the transmission channel of monetary policy.

What problem does the ECB face at present? Primarily, rising Italian and Spanish yields at the front end.

How can the ECB use its tools to deal with this problem? It could either buy Spanish or Italian bonds directly in an attempt to reduce their yields, or it could lend to banks in the hope that they will buy their own governments’ bonds.

Which of these is the ECB likely to do? Well, first of all, if Draghi’s verbal intervention is enough to bring down Spanish and Italian yields, it is likely to do neither. But assuming that it does feel the need to act, how can we work out what the ECB is likely to do? The success of the SMP has been mixed and 3-year LTRO’s have only been tried once so, unlike in the case of the Fed, it is probably not reasonable to use the ECB’s revealed reaction function to make a prediction. In the absence of specific knowledge about how to model the forward reaction function, I am inclined to fall back on a cost-benefit analysis.


Close to the wind on monetary finance prohibition
Committee discord
Governments getting direct help may feel less pressure to act
De facto seniority undermines effectiveness

Upward spiral in yields prevented


Necessary for ECB to take increasingly bad collateral

Upward spiral in yields likely prevented
Improves collateral position of banks as a side-effect

On the basis of this analysis, it would make more sense for the ECB to do another 3-year LTRO than to reactivate the SMP.

What if this happens? At the start of January, I said that the LTRO meant that it was likely that markets would rally — and they did, although I failed to execute and thereby make any money. Back then, rising Spanish and Italian yields were the reason that the equity market was relatively depressed — European growth had not yet fallen off a cliff, the US looked pretty strong, there were things for China bulls to be optimistic about, and nobody was sure whether the ECB, under a new President, would act. Now the US and China have clearly slowed, the economic picture in Spain has deteriorated markedly, and the ECB is known to be prepared to use some of the tools at its disposal. Even without the risk from Greece (and even the Troika seems to be losing its deluded faith in Greece’s ability to grow in spite of austerity), the backdrop has got worse since January. Back then, I thought the LTRO would be stimulative because it would remove a huge weight from the market’s back; now, I think it would be a marginal improvement in a deteriorating situation.

That means that it would be unreasonable for equities to return to their highs of April-May. And the S&P 500 is already pushing in that direction. I could short it today with a stop above the Spring’s post-GFC high. I might well do so.