Monday, August 27, 2012

ECB's bond purchases should start with Portugal

Given that the ECB has realized it is unable to target policy in some periphery nations (see this discussion), the central bank - assuming it does what people expect it to do - will focus on repairing the "monetary transmission" (transmitting low rate policy to the periphery). It really can't do too much with Greece at this point, but the central bank could focus on Portugal first. Portugal is supposedly on track with its fiscal plan (at least they have satisfied the Troika requirements). Yet the low rate policy transmission is broken, as short-term rates (as well as effective household borrowing rates) remain stubbornly high.

Periphery sovereign curves (Bloomberg)

JPMorgan: - The case for ECB intervention to aid monetary transmission [to Portugal] is clear. The case for action in other program countries is less clear: Irish yields are relatively low, while Greek compliance with program conditionality remains in doubt ahead of the Troika’s latest review. Action based on the rationale of repairing monetary transmission arguably has the best prospect of sustaining a majority on the Governing Council. And on that basis, we expect intervention in Portugal to begin after the Governing Council meeting has concluded.
As discussed (here) the ECB will target short-term rates - possibly up to three years. The goal is to lower rates in such a way as to reduce funding costs for households yet make sure the market "disciplines" the periphery governments on the long end of the curve. The ECB will then sterilize the purchases by offering term deposits.

Again, all this assumes that the ECB actually takes the logical steps based on Draghi's announcements. If the ECB does not start buying Portugal's paper fairly soon, it will be a signal that the markets have misinterpreted Draghi's intentions to fix the "monetary transmission". And it is entirely possible the central bank ends up delaying this bond purchasing program (discussed here) or morph it into something entirely different. But if all goes "according to plan", Portugal should be their first stop on the SMP-II program.
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