Rumors of ECB Bond Cap Program Dominate Markets

By FX Empire Analyst - Barry Norman
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The Foreign Exchange is acting a bit strange this Monday. With little eco data and even less news flow with commodity currencies like the Aussiekiwi and Looney leading the gainers while crosses like the GBP the JPY, and the EUR are little changed. 

Spanish spreads are in flux today, because Spain is perceived to be closer to making a formal request for aid to which the strings attached to granting aid may induce the ECB into buying its bonds. 

European equities are slightly higher across most major European indices while Dow futures are largely flat.

What explains the back and forth motion in markets this morning is volatility that is being induced by ECB speculation.  It started with a story in the German news magazine Der Spiegel that appeared over the weekend and that cited unnamed sources who indicated that the ECB may be moving toward implementing yield caps at its September 6th meeting.  Specifically, Der Spiegel reported that "the ECB is considering establishing in its future bond purchases interest rate levels for each country.

Thus, it would buy sovereign debt of the crisis countries whenever interest rates exceed a certain spread to German Bunds... At its next meeting in early September, the Governing Council will decide whether the interest rate target is actually installed."  This would entail unlimited bond purchases.  I don’t buy it on the surface of the claims, albeit that commenting on vague rumors is always difficult.  Yield caps through unlimited purchases would fly in the face of ECB President Mario Draghi’s assertions to date that ECB purchases would be targeted only to those countries that submitted formal aid requests to the EC and accepted the concomitant reforms. 

It would also almost assuredly draw criticism from Germany and indeed the salvos are flying quicker by the week on a deepening rift between the ECB and Bundesbank.  The Bundesbank noted today that “The Bundesbank holds to the opinion that government bond purchases by the Euro system are to be seen critically and entail significant stability risks.” 

The risk-on rally was short-circuited by the European mid-day as the ECB came out and commented that bond yield targets have not been discussed by the ECB council.  That in itself isn’t shocking because that would likely only occur by the ECB meeting on September 6th.

The idea has been floating around for several weeks and is likely a strategy that is being considered. Details of the program are undefined, however with spreads over German bunds still elevated (Italy +4.128%, Spain +4.543% and Portugal +7.736%) the potential scope of the program is notably large. The threat of moral hazard, whereby a sovereign would be less stringent with austerity and spending as the consequence of rising bond yields would ultimately be capped, is partially reduced as the ECB has already committed that it will not buy sovereign debt until the target country had agreed to the discipline of an aid program and associated MoU (memorandum of understanding). However, unlimited QE would ultimately share the burden of the European debt crisis among EMU members and be a step closer to fiscal ties.

The ECB has not commented on the possibility, nor denied it. Speculation over an ECB yield spread capping program was initially greeted with a small rally in the EUR. However, the Bundesbanks monthly report warned against an ECB-led bond buying program, stating that “enlarging the commoditization of solvency risks” is the responsibility of fiscal policymakers and should not be taken via central bank balance sheets, which put downward pressure on the currency. The euro returned to its prior trading channel and eventually slid to the bottom of the channel trading at 1.2308 down 0.036 in late afternoon trading.

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