How will the ECB’s new tool impact the financial market?

The ECB introduced its Transmission Protection Instrument (TPI) to replace the OMT.

The OMT proved spectacularly successful in reducing vulnerable country bond yields after it was introduced in September 2012 (although the OMT will continue to exist). With OMT being such a hit, surely it follows that the TPI will be equally successful?

The TPI is very similar to the OMT. However, conditionality has changed a bit in the sense that potential recipients of support under the OMT need to be under a fairly strict programme of supervision termed a European Financial Stability Facility/European Stability Mechanism programme. This conditionality was introduced back in 2012 because the ECB wanted to avoid giving struggling countries a free-ride by supporting their bond market without any budgetary discipline from the country in return.

At the time, there were many such programmes in place as a number of countries were in particular budgetary difficulties—labelled rather crudely at the time as the PIGS (Portugal, Ireland, Greece, and Spain). A decade on, deficits and debts might not have improved, thanks in part to COVID-19 costs, but the EU has a more lenient position now and, hence, while there is new conditionality on bond purchases under the TPI, they are perhaps not as onerous as they were under the OMT. But these are technical issues. Essentially, the OMT and TPI are pretty similar, and if the OMT worked to reduce bond yields for struggling countries, it might be assumed that the TPI would do likewise.

But here, we have to take account of the fact that there’s almost a mythical success attached to the OMT that came when former ECB President Draghi famously declared that the ECB would do "whatever it takes" to save the euro. Looking back, many seem to think that Draghi sent back the tide of bond market bearishness in a way that policymakers can only dream about. But the reality was a little different.

For a start, the sine qua non for successful intervention (or threat of intervention) in any market is that the authorities move in the same direction as market sentiment. Defending something when everyone else is in attack mode is very hard, especially if your resources are limit   ed. But defending something (like a bond market) when your "enemy"—the bond vigilantes—has started to turn is another matter. And, back in September 2012, the vigilantes had already started to turn. Yields were already going down in Greece and other countries, helped by government bailouts. This made the ECB’s job easier.

The second sine qua non of intervention is that it has to be done in the prevailing direction of monetary policy to be successful. Buying bonds to lower yields while, at the same time hiking policy rates is always going to be a challenge. But that wasn’t what was happening in 2012. The ECB had already made a couple of rate cuts before September 2012 and made many thereafter.

In short, the ECB was likely to succeed in 2012 because it had the wind in its sails. Today it is sailing into a storm. Yields are rising, and the ECB is in the process of tightening policy, not easing. So, while many may look back at 2012 with rosy-tinted spectacles and think that all the ECB has to do is to promise to buy unlimit   ed amounts of bonds to make the vigilantes run for cover, the reality is likely to be very different. What form is this "different" likely to take?

For a start, it seems likely to us that bond yields and spreads over core countries such as Germany will continue to rise. Unlike the OMT, which was never used, it looks to us that the TPI will be forced into action. Does that make it more likely to succeed? "Not in our view, given the issues we’ve talked about above. And what about the euro? Will that get dragged down? The announcement of the OMT in September 2012 did appear to help the euro rally after a very sticky patch, but, fast-forward to today and we think that things will just get stickier for the single currency", said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.