Two of our articles last month, touched on inflation, interest rates and bonds. Inflation in the EU is counting down the days to hit double digits, and a 75 basis point hike on interest rates is imminent. What do we know happens to bond prices when interest rates go up (and aggressively so)? They drop like flies, and as a result of the fixed coupon rate, their yields rise.
Why is this troublesome? High yields for a country’s bonds, means it has to pay more to borrow. In the case of Italy, with an already heavy debt load, the 4% on its – Buoni del Tesoro Poliennali (BTP) – 10 year yield, is a tough one to bear. The energy crisis is making things worse, pushing for more aggressive measures, and a tool that can take some of the yield pressure off, is seen as a good thing in the eyes of our policy makers. It’s a matter for debate but to each their own.
When government bond yields of weaker economies relative to stronger ones rise, its known as fragmentation. It needs some intervention to relieve the pressure, a tool, an anti-fragmentation tool.
What does the past tell us?
In the past (2009 onwards), the European Central Bank had a debt crisis to tackle. Member states were in over their heads and couldn’t pay their debts. Rumors had it (it was all over the news but we’ll call it rumors), exit from the Eurozone for some countries was a possibility.
What’s Eurozone? All the EU states that adopted the Euro as their currency. So exit from the Eurozone, would mean moonwalking back to their own currency. Thriller, right?
To deal with the crisis and prevent the Eurozone from breaking up, the Outright Monetary Transactions (OMT) tool was introduced in 2012, which taught us that “pari passu” means “on equal footing” among other things.
The ECB would buy sovereign (government) short term bonds (1-3 year duration) – as many bonds as it took – from highly indebted member states to secure their stay in the Eurozone. To onboard themselves on this ship, the countries would need to enter the EU bailout programs, cut spending and raise taxes. Pari passu referred to the treatment the ECB purchases would receive if the countries defaulted on their payment. “On equal footing” with other bond holders, means they would stand to lose just as much if things went sideways. Desirable outcome? – To drive the price of the bonds up and reduce their yields.
Under normal circumstances, central banks buy securities for quantitative easing. An open market operation, by which they flood a market (their own market) with money to stimulate the economy.
In contrast, quantitative tightening aims to reduce money supply by selling securities (gives people “title deeds” and takes money off their hands) often accompanied by increasing interest rates to cool down an overheating economy.
In the case of the OMT purchases though, stimulating the economy was not the plan. The money injected from the purchases could not stay in the economy. Therefore, these injections would have to be sterilized (raised eyebrow? it’s a real term). Sterilization happens when the ECB removes from circulation as much money as it injects. How? Through interest-bearing deposits parked with the ECB, of equal value as the bond purchases. This way money supply stays the same, while the goal for doing it in the first place is achieved. In this specific case, the goal was to drive bond prices up and lower their yields. See article on asset correlation for more information on bonds prices and yields.
Another way for ECB to sterilize its money injections, would be to issue other bonds for banks to buy and remove money from circulation or sell other assets it holds of equal value.
When OMT was introduced along with the famous “whatever it takes” Draghi statement, it calmed investors and Eurozone was back in business. So it was never actually used, but its very much alive and ready to deploy if needed today.
A central bank is a strong player and although able to temporarily solve problems it can also make things worse further into the future. For example, its important to note that a central bank doesn’t only finance it’s projects or pays its bills with “hard cash”. It is also able to print money to fund its programs, which is something that they do, more often than you think. And although countries like the US or EU are in better condition to deal with the consequences of printing money than smaller economies, its still a dangerous play and in the words of Charlie Munger “if you print too much money it eventually causes terrible trouble and the rate at which countries are printing money, puts us in a new territory in terms of size”.
It happened many times before in Europe, the US, Japan. Add in your search engine “Weimar Republic wheelbarrows of money” and look at the images that come up. Even with that much cash, people could only buy regular amounts of goodies because of hyperinflation that comes with printing money.
What is hyperinflation? When prices of goods and services rise at an alarming rate, rendering money worthless. Think of too much money chasing too few goods. Take the example of the over-reported Zimbabwe. The country’s inflation percentages are too mind boggling to even write about. A good example though, of a country with stagflation – remember Stag from a past article? A country with rising prices and low output resulting in low tax revenues, attempting to finance higher spending by printing money, just because it can. We’ll delve more into this another time.
Newest introduction to ECB’s toolbox – The Transmission Protection Instrument (TPI)
The OMT description above pretty much describes the idea of the new tool with some obvious differences. Firstly it doesn’t require member states to apply for a bailout program although it does ask for sustainable spending/debt. Also TPI is more flexible since it can purchase longer maturity debt of up to 10 years (rather than 3 years under OMT). It can also purchase private securities. More on the TPI on EU press release here
Last but not least, in the middle of it all, the Pandemic Emergency Purchase Program (PEPP). Unlike the OMT that was never used, the PEPP was heavily pushed during the pandemic (heavily as in Euro 1.850 trillion). According to ECB, it started with €750 billion, raised it by €600 billion in June 2020 and by another €500 billion in December.
Aggressive rate hikes will take place whether we like it or not. It’s good to know that sustainable tools exist to support the markets and more importantly, that they get better over time. Its apparent that just by knowing the cushion is there, it eases the troubled minds of investors who perform their acrobatics with a safety net. Whether the new tool will be used or not, it remains to be seen.
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