Columbia Management Perspectives: Question for the ECB - What Now?
By Fred Copper
Senior Portfolio Manager, Non US Equities
Senior Portfolio Manager, Non US Equities
10-year bond yields in Spain are getting close to the 6% threshold. We believe signaling sovereign credit stress is re-emerging in Europe. In fact, credit spreads in all the PIIGS (Portugal, Ireland, Italy, Greece, Spain) are on a widening trend. Admittedly, the behavior in Portugal is ambiguous, but at 12%, the level is not. I see 6% as an unsustainable level for Spain — either the authorities step in and drive yields down, or market pressure is going to force them higher. For context, 7% is the level where Greece, Ireland and Portugal all sought bailouts.
So what is the likely response to these renewed pressures? Political involvement thus far has been largely reactive and unreliable, so it is highly unlikely that the political sphere is the source of renewed calm. Layering on the fact that the bailout mechanism was expanded less than a month ago, it seems even less likely that any near term solution will be political. As has been the case for much of this crisis, that leaves the European Central Bank (ECB) as the protector of the European fort. I believe it’s quite possible the ECB has painted itself into a corner. First, any action at all will be controversial as it is already receiving pressure from Germany to unwind some of the measures previously taken, most notably the easing of collateral requirements that were part of the three year Long Term Refinancing Operation (LTRO) program. Second, any action it takes reduces the pressure on politicians to make the structural fiscal adjustments that can actually solve the crisis instead of merely delaying it. That being said, the sad reality is that the ECB will likely be forced to do something. My guess is that it will default to renewing one of its existing programs: the SMP (Securities Market Program — direct buying of sovereign debt) or another round of the three year LTRO. I’m assuming that if it had another trick up its sleeve, the ECB would have already used it — as we are years into this crisis.
Obstacles to the SMP:
1. They don’t have much capacity left to implement this program, so the ability to sustainably change the trend in rates is limited.
2. The implied subordination of market held bonds resulting from the ECB’s exemption to the Greek write-down will only be exacerbated by continued ECB buying.
Obstacles to the LTRO:
1. The banks filled up on liquidity during the past two rounds and probably don’t require much more — what they need is capital.
2. The neediest banks are running out of collateral, even with the easier standards.
3. The margin calls on the outstanding LTRO borrowings are already becoming problematic given declines in collateral values.
4. LTRO participating banks are underperforming non-participants, so the ECB claim that there is no stigma is self-serving hot air.
The ECB tipped its hand last week in terms of which direction it is likely to go. Board member Benoit Coeure indicated the ECB could step in and buy Spanish bonds. This statement was in part responsible for the rally in stocks and bonds. As already discussed, it is unlikely to be a sustainable solution. It wouldn’t be surprising to see renewed stresses emanating from the peripheral sovereign debt markets.
There is a limit to how much the ECB is going to be able to do in this situation. Ultimately, the real burden is going to have to be borne by politicians through substantial fiscal adjustments. The question is whether they can muster the resolve to put through difficult and often unpopular changes, and if so, can it be done willingly or is another market riot a necessary precondition.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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