Great Graphic: Mr Market Exaggerates

At first the ECB's NATO strategy--No Action Talk Only--produced a sharp sell-off of the euro and Spanish and Italian bonds, especially the long end.  On second thought, the half glass was really half full and there was a dramatic rally of the euro and Spanish and Italian bonds.  The idea was the the ECB was preparing to support the bond markets of the "virtuous" countries.  

The reaction was nothing shy of spectacular.  Consider the effect of the one-two punch beginning with Nowotny's comment on July 25, apparently re-floating the idea of the ESM getting a banking license from ECB, through Draghi's promise do what is necessary.  Leave aside the fact the ESM does not exist and that Draghi's mandate may prevent him from doing what is necessary. The Spanish 2-year yield has fallen nearly 300 bp and the Italian 2-year yield has fallen about 200 bp. The Spanish 10-year yield has fallen 75 bp and Italian 10-year yield has fallen a little more than 50 bp. The Great Graphic above from UK's Guardian puts the recent moves in Spain's yields and curve in a larger context. 

The Great Graphic to the left comes from an old chart from Scott Barber at Thomson-Reuters.  It illustrates that the ECB's Securities Market Program (SMP) of purchasing sovereign bonds did not appear to succeed in pushing yields down.   One might make a counter-factual claim that yields would have been higher if the ECB did not act, but that is not a testable hypothesis.  

ECB buying does change the ownership structure.  Even if the subordination is addressed as Draghi suggested, if seems to simply jump from one horn of the dilemma to the other.  Who is this official sector that will participate in haircuts?  It is tax payers.  If the ECB buys more bonds and participates in haircuts, and if it this does not amount to an illegal transfer, tax payers will have to recapitalize the ECB and/or national central banks.  

ECB bond buying also risks aggravating the key problem of the private sector in the creditor nations are no longer willing to recycle their surpluses toward the debtor nations.  By substituting official sector for the derelict or striking private sector, the ECB (and EFSF/ESM) contribute to the financial disintegration that we argue is of growing importance.  Some times, a short run fix pushes us further away from the long-term solution.  

The market appears to have exaggerated the significance of ECB bond purchases   Yet the decline in yields and the light supply schedule in the coming weeks serves to ease the "jumpers" off the ledge.  The situation is still quite fluid.  The market has taken Spain's feet out of the fire, to change metaphors, and this means Rajoy need not be pressured to formally request assistance.  However, his ability to negotiate is more limited when rates are higher and the situation more desperate.