Though we wonder if it’s still being underrated.
The ECB could now see a risk to its monetary policy — conducted in euros — from market pricing of peripheral bonds which assumes they won’t eventually be paid back in euros. And it could now act on this risk. However it might do this and with whatever facilities, it feels conceptually different to the actions which the market largely expects, which are versions of credit easing or liquidity for sovereign debt (the SMP).
It would also be pretty realistic in gauging why the real money won’t touch these bonds. Redenomination risk is now intimately tied to credit and liquidity risks. If Italy defaulted, it would hard for the country not to end up in a situation where it left the euro under duress, and its bonds would henceforth respond to rates set by the Bank of Italy in lira.
Nomura’s Kevin Gaynor came to these points in a Monday note, noting that they’re really mirror images of the convergence trades which led from ERM to EMU in the 1990s, when markets priced out FX effects in bonds:
Given markets knew the ERM central rates for the member states, participants had a high degree of confidence about the forward FX rate at a given time vs the euro and so covered interest parity held allowing investors to determine the interest rate/spot FX moves that gave the zero excess return in the run in to the start of the single currency in January 1999. The current situation is rather different but the identification by President Draghi of “convertibility risk” is a way of saying that the forward FX rate for each member has changed from zero and thus explains part of the yield spreads seen. Or seen from a different perspective there is a non-zero risk being priced of member states running different future monetary policies and thus different risk-free rates.
This interpretation allows us to think clearly about the repeated reference to the ECB’s mandate. It is not the ECB’s mandate to mitigate credit risk – this is the responsibility of the national sovereign, EU, EFSF and so on. But the implied FX risk falls squarely in the ECB’s remit. The shadow forward FX points within the euro may be what he is referring to.
Calculating how much is present is not an exact science of course, nor is separating out the liquidity premia. Furthermore there is a direct link between FX risk, credit risk and liquidity risk such that their co-movements are hard to separate out. But the approach is clever. Reminding markets that there should be no forward FX points for euro members is forceful and politically difficult for opponents of credit risk mitigation to argue against.
A crude measure is simply the CDS adjusted 5-year spreads of member states to Germany. As of today those spreads are around 50bp and 80bp at the 5-year maturity for Italy and Spain respectively, down from 135bp and 180bp three or four days ago.
This gives us some guidance on what the scale of ambition might be – not to crush spreads to zero, rather to remove implicit FX and liquidity risk, possibly worth about another 50-80bp at this maturity. Moreover, this motivation allows for action on an ongoing basis as required since it sidesteps the contingent bail-out element.
However, this approach to thinking doesn’t tell us much about how the ECB would insure itself against losses and therefore how it would rank vs the market.
That’s very much taking the view that the ECB would fight redenomination fear, where present in bond pricing, through buying bonds directly. Although we’d add that the “remit” could plausibly extend elsewhere, because redenomination fear takes more than one form. Depositor flight from the periphery, for example. It’ll definitely be interesting to see if Draghi is held to this “convertibility” comment during Thursday’s ECB meeting, or whether he walks it back.
One reason we think he should be held to it — the question of whether ECB liquidity policies have aided the fragmentation of a single eurozone monetary policy. All that creeping reliance on national central banks taking things at their own risk on taking some forms of collateral, or the long-term nature of some national central bank ELA.
The strange status of those euros of liquidity, not a million miles from doubts over the euros of some peripheral bonds?
(Re-risking the eurozone) The benefits of naked CDS – FT Alphaville (2010)