Friday, August 3, 2012

Uh, So, Maybe Draghi Meant Something Different

The markets seem to be rethinking yesterday's message. This is Olaf Storbeck of Handelsblatt via FT Alphaville:


Between the lines the message was perfectly clear. The Bundesbank might not like it, but the ECB will intervene in the bond markets in the foreseeable future. And big time.
From my perspective, the most important piece of the speech was Draghi’s implicit acknowledgement that the ECB has a target rate for bond yields. Draghi described the current yields as unacceptable and he stressed that the ECB “may undertake outright open market operations of a size adequate to reach its objective”.
He did not reveal where the ECB’s pain barrier is. However, the mere acknowledgement that the ECB has a certain threshold in mind is quite something. If Draghi means what he says, it follows that the bank is ready to buy bonds without any limits.
So, bottom line: Spanish yields will be allowed to rise only so high. We won't tell you how high, but somewhere around the level reached last week. This means investing in Spanish debt is "safe" (with an implicit ECB guaranteed floor price), so if you can borrow at a low rate, say around 2%, and earn a spread of 4.5 to 5% investing in Italy or Spain, you've got a nice carry trade. But you have a couple of downside risks: the ECB guarantee stays in place only as long as the peripheral governments play ball, that is, toe the austerity line; and if the continued squeeze makes people desperate enough to topple one of these governments, or even force an existing government off the ECB line, you can lose your shirt. How will the big investors perceive this offer from the ECB? They are desperate for yield, but these risks are not small.