Yield caps would give ECB powerful weapon
FRANKFURT (MarketWatch) -- The European Central Bank sought Monday to cool speculation it may soon move to cap government-bond yields in the euro zone, although economists said such a move would provide the institution with a powerful weapon in the fight to contain a debt crisis that threatens to tear apart the shared currency.
Germany's Der Spiegel magazine, without citing sources, reported over the weekend that the central bank was weighing a plan to buy troubled government bonds in unlimited quantities if the yield premium demanded by investors to hold the bonds over safe-haven German paper exceeded an unspecified level.
An ECB spokesperson responded on Monday , saying it was "absolutely misleading" to report on decisions that haven't been made yet.
But a decision by the ECB to draw a line in the sand would go a long way toward restoring investors' confidence in euro-zone government bonds, said Gary Jenkins, head of independent credit firm Swordfish Research in London.
"If you're a bond investor and you've got that kind of ammunition ... you're more likely to invest alongside the central bank [than] not. One thing you're not going to do is be short" in the bond market, Jenkins said, in a telephone interview.
It would also mark an about-face by the ECB, which has so far treated bond investors as "the enemy" rather than a crucial ally necessary to see the euro zone through the crisis, he said.
The euro gave up early gains after the ECB sought to pour cold water on the Spiegel report. The shared currency traded at $1.2315 in recent, range-bound action, down from $1.2327 in North American trade late Friday.
Spanish government bonds trimmed gains but still added to their recent rally, pulling yields lower.
The yield on the 10-year Spanish government bond (10YR_ESP) fell 0.15 percentage point to 6.27%. The spread between yields on the Spanish bond and 10-year German bund narrowed 0.18 percentage point to 4.75 percentage points.
Spanish and Italian bond yields have fallen back from crisis levels since ECB President Mario Draghi last month said the ECB would do "whatever it takes" within the central bank's mandate to preserve the euro. The rally has been led by the shorter-dated debt. Draghi said any future bond-buying efforts would be focused in that area of the region's yield curves.
Surging Spanish borrowing costs this summer reignited fears the euro-zone's fourth-largest economy could be forced to seek a full, sovereign bailout, leaving potentially too-big-to-rescue Italy next in the firing line.
By focusing on the premiums demanded by investors to hold peripheral debt over German bunds, the ECB would be taking aim at the issue of "financial fragmentation" that Draghi highlighted in his London speech last month.
Draghi argued that the large premiums demanded by investors reflected not only worries about default and liquidity but also concerns about "convertibility." In other words, investors are reluctant to hold some government bonds out of fear the issuer could leave the euro, re-denominating the debt in a new currency. Moreover, those premiums show the impact of easier ECB monetary policy has been blunted.
"Now to the extent that these premia do not have to do with factors inherent to my counterparty, they come into our mandate. They come within our remit," Draghi said in his July 26 speech. "To the extent that the size of these sovereign premia hampers the functioning of the monetary-policy transmission channel, they come within our mandate."
Ahead of the ECB response to the Spiegel report, analysts had cautioned that a target approach could prove problematic.
"Unlimited bond purchases would constitute the final step towards a monetization of the peripheral countries' debts. It would commit the ECB to solving the European debt problems by printing money," wrote Carolin Hecht, currency strategist at Commerzbank.
She argued that the "legitimate cover story" for the ECB's past bond purchases -- addressing dysfunctional bond markets -- would no longer serve as an explanation.
"On the contrary: If the ECB was to pursue a policy of this nature it would completely ruin the indicator function of the bond market. The ECB would be taking action outside its mandate," she said, in a research note.
Committing to "unlimited" purchases, difficulties with determining the "correct" level to set the spreads, were seen among potential roadblocks, wrote Peter Schaffrik, fixed-income strategist at RBC Capital Markets. In a note last week, Shcaffrik said the ECB was more likely to set a quantitative target for bond purchases rather than targeting yields or spreads.
But if the ECB is prepared to go that route, "we believe that a cap on yields/spreads is even more powerful than a buying program with pre-announced sizes -- even if those are large," Schaffrik said on Monday.
Steven Barrow, currency and fixed-income strategist at Standard Bank in London, said backers of a spread-targeting plan will likely argue that the threat of intervention by the ECB would keep sellers at bay, limiting the total amount the ECB would have to buy.
"But those sceptical of such a system will presumably argue that the setting of a currency limit in Switzerland for euro/Swiss has still meant that the [Swiss National Bank] has had to intervene massively, as reflected in surging FX reserves," he said, in a note.
The SNB last year set a CHF1.20 floor for the euro/Swiss franc pair in a so-far successful effort to cap the rise of its own currency.