Busch: ECB Prepares, but Doesn’t Act


Today, the European Central Bank (explain this) surprised the markets by not acting to cut interest rates. They left their main refinancing rate at at 0.75%, marginal lending at 1.5% and deposit facility at 0.0%.

The EUR/USD rallied after the announcement. However, the source of the optimism appears to be occurring elsewhere. The FT carries a story on Spain’s PM Rajoy and Italy’s Montimeeting amid hopes for action. Here’s the key sentence: “The most likely scenarioaccording to some analysts and European officials is for an agreement in September for the EFSF (explain this) to buy Spanish and Italian debt on the primary market, with the ECB weighing in on secondary markets if necessary.” The market appears to be taking this as a firm agreement.

For the EFSF to buy a sovereign’s debt, the sovereign must make an official application for a bailout. This means the sovereign must come under the scrutiny of the EU and IMF and must follow the plan they establish to get the sovereign back into better fiscal condition. This is what Spain wants to avoid as they don’t want to give up their own sovereignty and control. This is why Spain has yet to ask for an official bailout and why Monti is meeting with Rajoy.

Yet, the one lesson we should’ve learned from 2008 is that there are rules and then there are rules under duress.

The Federal Reserve’s massive expansion of the 13(b) section of their code that states “In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may …,” essentially do whatever it thinks is necessary to keep the system intact. This allowed the Fed to make $29 billion in loans to JPM for its purchase of Bear Stearns. With the EFSF, there is similar wiggle room under the “Precautionary Programmes” section of the bailout facility that could allow the fund to buy Spanish debt without a formal program. Therefore, there is a way for the EFSF to buy Spanish debt. The question remains if there is the will of European financial leaders to allow it to happen.

At his press conference today, the European Central Bank President Mario Draghi stated that governments must stand ready to activate EFSF. He said ECB may take measures to ensure policy transmission (this is the equivalent of Fed’s 13(b)), but that the ECB can’t replace governments. Here’s the critical text section from the introductory remarks:

“The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”

The ECB is preparing for non-standard measures, but it appears they are awaiting an official request to do so. When asked about the timing of any new ECB bond buys, Draghi said they may act when governments apply to EFSF with the right conditionality.

Clearly, this was underwhelming to markets who were expecting a detailed, formal plan today. Upon this news, the EUR/USD dropped from 1.2400 to 1.2190 and Spanish 10yr bond yields back up over 20bps to 6.83%. (Draghi did say they would be focused on the short end of the yield curve.)

Today’s information supports my view that the market was set-up to be disappointed and on that, I was not disappointed. My central view remains that difficult political decisions must be made to structurally reform European economies to generate growth. These take time and the process is unsanitary. At best, today shows the process is on-going and slowly moving forward.

At worst, today shows that there will be no massive ECB action without a formal request by a sovereign.

Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.