Please, click here to read this article in pdf format: may-10-2010

Last Thursday we published a dialectic monologue to convince ourselves that the action in the markets was not justified, if the European Central Bank (ECB) was indeed going to monetize sovereign debt. Unfortunately, we underestimated the political aspect of the issue. Mr. Trichet decided it was better to say he had not discussed the possibility of buying sovereign debt, than to remain silent. Confusion reigned and we had the apparent technical glitch affecting global markets.
Before we go on, we note that over the weekend EU members agreed to a EUR750BN bailout plan to defend the Euro. We think this is delusional. A bunch of bankrupt countries setting up a fund? With what currency? The same currency they claim they will defend, when its value precisely plunged because they had their debts monetized with collateral lines from the ECB?

Let’s begin today reaffirming our view that the ECB will have to monetize sovereign debt, if it wants the Euro to survive. If it does so, a rally will follow and if it doesn’t, the situation will exponentially worsen, dragging Emerging Markets to the level it did with North America. The decision to set up a fund means that for the moment, the ECB is delaying this monetization.
With this in mind, there are two potential monetization alternatives, which we want to examine today:

-Scenario A: The ECB actively purchases sovereign debt from governments (i.e. Fed’s $300BN Treasury purchase program). Currently, the ECB cannot monetize sovereign debt. This would require special legislation.

-Scenario B: The ECB buys sovereign debt in the secondary market (i.e. from financial institutions).

We think it has merit to examine the two scenarios and suspect that also at the ECB, these scenarios must have been or are being examined in detail. Therefore, today we want to discuss their implications…what to expect while we are expecting:

-What should be the yields on an absolute and relative basis?
Under scenario A, the element of “price discovery” disappears. With the ECB purchasing directly from governments, the market relies on the price signals provided by the central bank. This would not be so bad in a normal situation (i.e. one country), however, in the case of the European Union, we don’t have only one sovereign. There are many issuers and the problem is that there is no unified bond market. Will the ECB therefore be allowed to impact the determination of relative prices/yields among issues of member governments (i.e. Greek sovereign yield vs. German sovereign yield)? On what guidelines?
To a lesser degree but also relevant, the ECB would be impacting the relative prices of sovereign debt, if it buys it in the secondary. How much from Greece or Portugal should it buy? At what prices? Par?

-Crowding-out effect on private sector:
Under scenario A, the ECB crowds the private sector out. Under B, by definition (i.e. secondary market), the market has already decided what resources to allocate to private and public sector investment opportunities. Under A, the allocation is indirect but real, because once governments get their newly printed, fresh monies, they will purchase resources they would have been unable to afford otherwise…resources that had been there for the private sector to buy, and are no longer.

-Behavioural perspective:
Probably, under scenario A, issuers (i.e. governments) are not actively encouraged to reduce their deficits. Under scenario B, on the other hand, banks would likely generate a “bubble” in sovereign debt, by arbitraging yields between sovereigns. After all, if the ECB bought distressed sovereigns (i.e. near-term probability of default turns nil), why would banks pay more for Bunds, when they could get a higher yield with the same risk out of PIGS debt. What was before default risk becomes counterparty risk, with the ECB as the counterparty.  Probabilities of default (in the near term) “disappear”, and recovery is 100%.

-What would determine the supply of money and what would be the exit strategy?
We think that under scenario B, the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, under scenario B, the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy under scenario B? In the long run, the only way out for the ECB under scenario B is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy in scenario B.

In theory, under scenario A, the ECB could arbitrarily somewhat manage the supply of money, deciding when to participate in the auctions (i.e. impacting the growth rate of money supply) and manipulating the benchmark yield curve (i.e. deciding how to allocate the purchase limits to different points in the yield curves).

Under scenario A, there is more transparency. The market ex-ante knows how much will be monetized. But this is a double-edged sword, because once this amount is announced, the market has the final word. An example of this point is yesterday’s bailout announcement. We will see the reaction today, although we anticipate it will likely be positive.

Scenario A is “easier” and there are tools available to set up an exit strategy (beyond the scope of this letter). However, even if such tools are available, a successful exit strategy would need the ECB to be politically independent.

-What would be the impact on the Euro?
Under both scenarios, the value of Euro would plunge. This is an important conclusion. Would the Euro not also lose its status as a reserve currency? It is already losing it and would definitely lose it under both scenarios. Perhaps under scenario A, given that the monetization amount is known ex-ante, foreign central banks would have more certainty to speculate on the scope of the devaluation of the Euro. In that case, gold would tend to appreciate less than under scenario B. In scenario B, there is never certainty on the final amount of debt. Scenario B, in our opinion, would open the door to hyperinflation in Europe.

Martin Sibileau