Another existential threat for the euro

The euro is already under a great deal of pressure against the dollar.

>> The inflation conundrum for ECB

When the ECB threatened bond market intervention in 2012, as the periphery bond markets imploded and the euro fell, it seemed that the market listened because calm was restored and the ECB never even had to conduct intervention under the Outright Monetary Transactions (OMT) plan. Why was it so successful and could the trick be repeated this time?

While the euro was not part of the intervention equation in 2012, as the focus was on bonds, Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks that currency markets could still offer a clue to why the OMT was successful back then – and why the new plan might not be successful this time.

"If we were to ask what makes for successful currency intervention (for here we have much more evidence of success and failure than bond market intervention), we’d suggest that it is important for the intervention to follow the prevailing direction of monetary policy. What we mean by this is that, if a central bank wants to defend a weak currency, it is much more likely to have success if monetary policy is being tightened at the same time. In other words, intervention should follow the general thrust of monetary policy. If it does not, then intervention is less likely to be effective. We do not think that intervention in the bond market is any different; in fact, it might be even more important that intervention follows the direction of monetary policy", said Mr. Steve Barrow.

As a result, its efforts to lower rates in peripheral eurozone bond markets were policy-oriented. Fast forward to today, and the ECB is devising a plan to reduce yields in periphery bond markets at a time when policy is being tightened. In other words, the situation is very different and so might be the chances of success.

Now, clearly the ECB, or any other defenders of the new plan, will argue that any bond market intervention will be sterilised so that it has no monetary policy implications. It is thought that the ECB will announce that it will hold auctions that pay banks above the usual rate on their deposits with the central bank. Of course, it is possible that these auctions will be undersubscribed and hence some unsterilised bond market intervention will leak out, but that’s unlikely and not necessarily the biggest problem anyway.

>> A boost for euro

Returning to FX intervention, it is usually argued that unsterilised intervention is more effective than sterilised action, which again reflects this idea of moving in line with the prevailing monetary policy. By sterilising intervention in the bond market, the ECB might avoid easing monetary policy, but Mr. Steve Barrow still feels that the effectiveness of bond purchases will be less than if the bank were acting at a time when it wanted to ease monetary policy, as it did in 2012.

The way in which sterilisation takes place could also have a bearing on the policy’s effectiveness in the bond market. As said earlier, the ECB appears likely to want to sterilize through auctions, which presumably will be open to all banks across the euro zone. As an alternative, it could buy bonds in weaker periphery countries while simultaneously selling bonds in core countries, such as German bunds.

In Mr. Steve Barrow’s view, the FX example is useful again because selling German bunds to sterilise is a bit like buying the euro against the dollar, while the auction approach is a bit like diluting the euro purchases by spreading them across a whole range of currencies. There is a lot more that we could say on this topic as we’ve barely scratched the surface, but the key takeaway for us is that the ECB’s new bond market intervention plan won’t be as successful as the last one, and that poses a danger to the euro as well as those higher-yielding periphery bond markets.