The chart above shows the decline in Spanish bond yields “occurring at a time that Spain has announced that it had not hit its deficit targets and would not hit next year’s,” as David Watts of CreditSights points out.
There’s a reason for the steadiness of the rally — but first, a step back before looking at why it matters and what it says about last week’s ECB decision on rates.
Anti-austerity momentum, at least in gesture
In a post Friday, we highlighted the numerous recent instances of eurozone officials openly expressing the view that the push for austerity should be softened, at least temporarily.
Included on the list were comments by Italian prime minister Enrico Letta, EC president José Manuel Barroso, German finance minister Wolfgang Schauble, and economic and monetary affairs commissioner Ollie Rehn. And it could also have included the remarks by Christine Lagarde in April.
Missing from the list, of course, is Mario Draghi, who went the other way at Thursday’s ECB presser and cautioned that “euro area countries should not unravel their efforts to reduce government budget deficits”. He repeated a similar message in a speech earlier on Monday.
But unlike the other trials balloons floated at the presser, this might be a case of watch what I do, not what I say.
Spain and the ECB
In the case of Spain, it’s important to remember just how it is that the ECB functions as the final liquidity backstop for the sovereign. In a time of extreme stress, the Spanish government could sell its debt to the domestic banks, which could then pledge the debt as collateral to the ECB (through the Spanish central bank).
In other words, it isn’t the IMF or the EC that have to worry most about the Spanish sovereign and Spanish banks coming under pressure — it’s the ECB, as funder of last resort.
Watts writes (emphasis ours):
That backstopping of Spain’s funding position is available as long as the ECB is willing to accept the government securities as collateral and at least some Spanish banks are solvent. Given that Spanish banks have recently been recapitalised and the ECB (along with the EC and the IMF) has expressed no concerns about the deficit, the risk of the backstop (that results from the ECB’s willingness to accept Spanish bonds as collateral) being removed is relatively remote. …
The ECB’s explicit (although dependent on conditions being agreed between Spain and Eurozone governments) backstopping of Spain’s one to three year bonds had already prompted fairly sizeable reductions in shorterdated instruments’ yields. But the growing perception of an implicit backstop via the ECB financing being available as a last resort has further depressed yields across the curve.
The result is that larger deficits within the Eurozone, while potentially inflationary over the longer term, are being tolerated as a fact of life for Eurozone economies (or at least systemically important ones).
This matters for Spain because the meaningful deficit reduction of the past year came from a combination tax hikes and public sector wage cuts.
[The "bailouts" refers to last year's bank recapitalisation.]
These tax hikes included raising VAT and corporate tax rates.
Back to Watts:
But repeating those measures and delivering similarly large reductions in the 2013 and 2014 deficits will be difficult politically given the extent to which the pain is already falling on Spanish households. While corporate revenues dropped by €3 bn in 2012 (a 0.5% drop), a €17 bn (5%) cut in wages to employees meant that net operating surplus (a rough gauge of profits) rose by €6 bn. In contrast, the compensation of Spanish employees fell by 5.4% in nominal terms in 2012. The decline in the fourth quarter alone was 3.9% (14.6% on an annualised basis). At the same time consumer prices rose by 3% in 2012 largely due to the increases in VAT in September (without the effect of taxes inflation in Spain would have been 0.8%).
More such measures, and thus further deficit reduction of a similar magnitude, are unlikely — as is a significant rebound in tax revenues given that state of the economy.
All of which shows again why the rally in Spanish yields probably wasn’t about the deficit reduction itself, aggressive though it was. The more likely explanation was the perception that the ECB is, if not happily accepting, then at least willing to tolerate Spain’s missing its budget deficits.
A less-heralded commitment
Now we come to what happened at last week’s ECB announcement and presser. Most of the subsequent commentary focused on the main refinancing rate cut, the hint of a negative deposit rate, and the commitment to spur lending to small- and medium-sized companies.
But our pal Lorcan Roche Kelly of TrendMacro emphasised something different in his latest note:
Most critically, in his speech at the press conference, ECB President Mario Draghi also gave the longest forward commitment yet to the continuation of weekly fixed-rate full-allotment refinancing operations by the ECB: they will now continue until July 2014. As forward guidance goes, this is a pale shadow of the Fed’s policies, but it is a major step for the ECB.
– This move is not exactly another long-term refinancing operation (LTRO). Rather, it is a long-term commitment by the ECB to provide limitless liquidity every week, on a short-term basis.
– It is roughly analogous to a 15-month LTRO that banks can access on a weekly basis.
– It renders meaningless much of the free option given by the 3-year LTROs. The two 3-year LTRO operations only extend for five and seven months, respectively, beyond the new commitment from the ECB.
– This may well lead to increased early repayments of the current outstanding 3-year LTROs. For banks the upside to remaining in the operations has been largely removed today.
– As the terms are fixed until July 2014 at the earliest, banks can now be assured of funding when they need it in the short to medium term, without being forced to access it immediately — as happened in the 3-year LTROs.
Draghi’s recent comments are being mainly interpreted as a double-down on austerity. That’s not wrong and it remains unfortunate, but there are several complicating factors that are nonetheless worth remembering.
One is simply that Draghi probably needs to keep reiterating the importance of budget constraints for internal political reasons (giving himself cover at the Bundesbank).
Another is that Draghi has long been more concerned with structural changes in labour markets and economies than in broad-based austerity for its own sake, as Lorcan notes. Draghi is generally against tax hikes, for instance, and would prefer spending cuts. Of course, this particular nuance isn’t exactly comforting given the brutal choices faced by the countries on the periphery.
But a third is that Draghi’s re-commitment to the eurozone banking system last week might be understood as a way to get around the busted transmission mechanism for monetary policy in the south — and therefore his insistence on deficit targets is somewhat watered down. The revelation that several countries’ targets (Spain, France, the Netherlands) will be missed this year has done little to change that.
With the extension of the weekly fixed-rate full-allotment refinancing operations and the intent to help SMEs, the ECB is essentially signalling that it would be happy to use the banking system as a means of providing funding that reaches the real economies in the south.
Details on what kind of support the ECB would provide are still unknown, and the program is unlikely to be big. But in whatever shape the lending takes — whether more bank loans guaranteed by the European Investment Bank or SME securitisations — the ECB will ultimately be providing liquidity to the system.
Two charts from Morgan Stanley illustrate the problem:
Borrowing costs for companies on the periphery have diverged from those in the core, which makes the 25bp cut in the main refinancing rate essentially a symbolic gesture. But the SME options at least would have a chance to making borrowing possible for the firms that do still need it. This is monetary easing by any understanding of the phrase.
Yes, it is also weak beer given the scale of Europe’s problems, and the more aggressive measures needed — from fiscal and monetary policymakers alike — remain politically improbable.
But at the very least, it suggests that the ECB’s rhetoric in favour of continued austerity — not just in Spain, but elsewhere — can be taken with a grain of salt, if not a large one.