Yesterday the ECB ( European Central Bank ) President Mario Draghi spoke at the European Parliament and in his speech were some curious and intriguing phrases.
Our current monetary policy stance foresees that, if the inflation outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council is prepared to increase the asset purchase programme in terms of size and/or duration.
I say that bit was curious because it contrasted with the other rhetoric in the speech as we were told how well things are going.
Over the last two years GDP per capita has increased by 3% in the euro area, which compares well with other major advanced economies. Economic sentiment is at its highest level in five years. Unemployment has fallen to 9.6%, its lowest level since May 2009. And the ratio of public debt to GDP is declining for the second consecutive year.
The talk of what I would call “More,More,More” is also a contrast to the December policy decision which went down the road of less or more specifically slower.
We will continue to purchase assets at a monthly pace of €80 billion until March. Starting from April, our net asset purchases will run at a monthly pace of €60 billion, and we will reinvest the securities purchased earlier under our programme, as they mature. This will add to our monthly net purchases.
There was another swerve from Mario Draghi who had written to a couple of MEPs telling them that a country leaving the Euro would have to settle their Target 2 balances ( I analysed this on the 23rd of January ) whereas now we were told this.
L’euro e’ irrevocabile, the euro is irrevocable
Of course Italian is his natural language bur perhaps also there was a message to his home country which has seen the rise of political parties who are against Euro membership.
Such words do have impacts on bond markets and yields but I was particularly interested in this bit. From @macrocredit.
DRAGHI SAYS ECB POLICY DOESN’T TARGET BOND SPREADS
A rather curious observation from someone who is effectively doing just that and of course for an establishment which trumpeted the convergence of bond yield spreads back before the Euro area crisis. Just to be clear which is meant here is the gap between the bond yield of Germany and other nations such as Spain or Italy. These days Mario Draghi seems to be displaying all the consistency of Arsene Wenger.
Oh and rather like the Bank of England he seems to be preparing himself for a rise in inflation.
As I have argued before, our monetary policy strategy prescribes that we should not react to individual data points and short-lived increases in inflation.
Spanish energy consumers may not be so sanguine!
Growing divergence in bond yields
The reality has been that recently we have seen a growing divergence in Euro area bond yields. This has happened in spite of the fact that the ECB QE ( Quantitative Easing) bond buying program has continued. As of the latest update it has purchased some 1.34 trillion Euros of sovereign bonds as well as of course other types of bonds. Perhaps markets are already adjusting to the reduction in the rate of purchases planned to begin on April 1st.
Ch-ch-changes here are right at the core of the Euro project which is the Franco-German axis. If we look back to last autumn we see a ten-year yield which fell below 0.1% and now we see one of 1.12%. This has left it some 0.76% higher than its German equivalent.
Care is needed as these are still low levels but politicians get used to an annual windfall from ,lower bond yields and so any rise will be unwelcome. It is still true that up to the five-year maturity France can borrow at negative bond yields but it is also true that a chill wind of change seems to be blowing at the moment. The next funding auction will be much more painful than its predecessor and the number below suggests we may not have to wait too long for it.
The government borrowing requirement for 2017 is therefore forecast to reach €185.4bn.
Here in Mario’s home country the situation is more material as the ten-year yield has risen to 2.36% or 2% over that of Germany. This will be expensive for politicians in the same manner as for France except of course the yield is more expensive and as the Italian Treasury confirms below the larger national debt poses its own demands.
The redemptions over the coming year are just under 216 billion euros (excluding BOTs), or some 30 billion euros more than in 2016, including approximately 3.3 billion euros in relation to the international programme. At the same time, the redemptions of currently outstanding BOTs amount to just over 107 billion euros, which is below the comparable amount in 2016 (115 billion euros) as a result of the policy initiated some years ago to reduce the borrowing in this segment.
The Italian Treasury has also noted the trends we are discussing today.
As a result of these developments, the yield differentials between Italian government securities and similar securities from other core European countries (in particular, Germany) started to increase in September 2016……. the final two months of 2016 have been marked by a significant increase in interest rates in the bond market in the United States,
Although we are also told this
In Europe, the picture is very different.
Anyway those who have followed the many debacles in this particular area which have mostly involved Mario Draghi’s past employer Goldman Sachs will note this next bit with concern.
Again in 2017, the transactions in derivatives instruments will support active portfolio management, and they will be aimed at improving the portfolio performance in the current market environment.
Should problems emerge then let me place a marker down which is that the average maturity of 6.76 years is not the longest.
Here the numbers are more severe as Portugal has a ten-year yield of 4.24% and of course it has a similar national debt to economic output ratio to Italy so it is an outlier on two fronts. It need to raise this in 2017.
The Republic has a gross issuance target of EUR 14 billion to EUR 16 billion through both auctions and syndications.
To be fair it started last month but do you see the catch?
The size was set at EUR 3 billion and the new OT 10-year benchmark was finally priced at 16:15 CET with a coupon of 4.125% and a re-offer yield of 4.227%.
That is expensive in these times of a bond market super boom. Portugal has now paid off some 44% of its borrowings from the IMF but it is coming with an increasingly expensive kicker. Maybe that is why the European establishment wanted the IMF involved in its next review of Portugal’s circumstances.
Also at just over five years the average maturity is relatively short which would mean any return of the bond vigilantes would soon have Portugal looking for outside help again.
As of December 31, 2016 the Portuguese State direct debt amounted to EUR 236,283 million, decreasing 0.5% vis-à-vis the end of the previous month ( 133.4% of GDP).
Bond markets will of course ebb and flow but recently we have seen an overall trend and this does pose questions for several countries in the Euro area in particular. The clear examples are Italy and Portugal but there are also concerns elsewhere such as in France. These forces take time but a brake will be applied to national budgets as debt costs rise after several years when politicians will have been quietly cheering ECB policies which have driven falls. Of course higher inflation will raise debt costs for nations such as Italy which have index-linked stocks as well.
If we step back we see how difficult it will be for the ECB to end its QE sovereign bond buying program and even harder to ever reverse the stock or portfolio of bonds it has bought so far. This returns me to the issues I raised on January 19th.
If we look at the overall picture we see that 2017 poses quite a few issues for central banks as they approach the stage which the brightest always feared. If you come off it will the economy go “cold turkey” or merely have some withdrawal systems? What if the future they have borrowed from emerges and is worse than otherwise?
Meanwhile with the ECB being under fire for currency manipulation ( in favour of Germany in particular) it is not clear to me that this from Benoit Coeure will help.
The ECB has no specific exchange rate target, but the single currency has adjusted as a consequence. Since its last peak in 2011, the euro has depreciated by almost 30% against the dollar. The euro is now at a level that is appropriate for the economic situation in Europe.