Summary
Last week, the ECB ended years of negative rates with a bold 50bps hike. Then, the bank introduced the Transmission Protection Instrument (TPI). This tool will allow the ECB to purchase bonds of countries where spreads have risen significantly. TPI solves the ‘how do you raise rates without endangering Italy’ conundrum.
However, markets didn’t cheer. Unlike her predecessor, Mr Draghi, Ms Lagarde was careful to properly caveat the endeavour. But a careful read through, suggests that there was no need for bold words. The ECB is much better equipped now to face crises.
Since the onset of this new crisis, the Euro has been the biggest risk on our radar. It still is. The European bond market is stressed, and so is the currency. But so far, it is not distressed. We feel that markets might eventually try to test Ms Lagarde. Having said that, following last Thursday’s policy announcement we feel more confident that attacks on the Euro might be thwarted.
In 2012, Mario Draghi, then Chair of the ECB, was staring down the barrel of the the total collapse of the Euro. At the height of the crisis, he stood up and boldly pronounced:
‘We will save the Euro, whatever it takes’.
Then paused for effect, looked around the room and added:
‘And trust me, it will be enough’.
Pretty bold, considering that when he said it, the Euro had almost collapsed, there was no plan and the ECB had no mandate to print money. No one had approved the comment. Germans were shocked to hear of a hint of QE, a step towards European debt mutualisation. It was the mother of all ‘Hail Marys’. Bond investors, who had already lost betting against American QE, were afraid of what another ‘Bazooka’ might mean for their returns. Angela Merkel, of course, had remained silent. She was happy to let markets believe what they want to believe, until she had time to put a plan together.
A gamble that worked, but a gamble nonetheless.
Now when Draghi said that, with absolutely no plan, markets took him at his word. Afraid of challenging another central bank, investors ate it, rod, line and sinker. This gave enough space to the Eurozone to come up with the right tools to save the monetary union. And still, the whole thing almost came apart in 2015 again, when Greece was almost ejected from the Union.
A decade later it’s Ms Lagarde who leads the ECB. Her pronouncements were much more careful. On the one hand, she ended years of negative rates (a questionable practice to begin with). A 50bps hike was very bold.
Then, she introduced the Transmission Protection Instrument (TPI). This tool will allow the ECB to purchase bonds of countries where spreads have risen significantly. It solves the ‘how do you raise rates without endangering Italy’ conundrum. But she was careful on how she phrased it. She mentioned the four conditions for potential recipients:
They must be in line with the Eurozone’s fiscal rules
They mustn’t have severe macroeconomic imbalances
Their debt trajectory must be sustainable
Their macro policies also need to be sustainable
This means that the ECB would still decide whether a country ‘deserves’ to be saved. This is important. No matter how big Italy is, if election was held today, polls suggest that Eurosceptic parties would get 52% of the vote. Italy itself would have to decide whether it wants to play by the rules.
Markets were sceptical. This was not a big grandiose statement, despite Ms Lagarde’s pledge that there’s no upper limit to those instruments. There were caveats. The Euro remained weak. Italian spreads remained high.
However, investors forget that where in 2012 noting really stood behind Mr. Draghi’s bold words, today the ECB has a lot more tools in their disposal
The TPI
The OMT (Outright Monetary Transactions)
The ELA (Emergency Liquidity Assistance)
And of course, QE itself.
More importantly, the EU has already made huge sacrifices to keep the common currency together. There’s no desiree to keep In 2012, the Euro crisis was still fresh, and so was the debate. Now the Eurozone stands a lot closer.
Mr. Draghi spoke bravely, but he bluffed. Those of the Anglo-Saxon conviction should certainly appreciate someone speaking softly and carrying a big stick. And make no mistake, the ECB is the second largest global central bank. Ms. Lagarde’s stick is big enough.
As investors, we think there are two conclusions after the ECB’s heavily caveated rate hike yesterday:
The ECB is serious about throwing money around to save the Euro. We will see political wrangling, but then again when is that not a feature of Eurozone politics?
Gambles may sometimes work. But they are hardly an investment strategy. Investors need to look past bold policy statements, understand that different people express themselves differently, and focus on actual policies, as well as the ability and dependability of those in charge to implement them.
Since the onset of this new crisis, the Euro has been the biggest risk on our radar. It still is.
The European bond market is stressed, and so is the currency. But so far, it is not distressed. We feel that markets might eventually try to test Ms Lagarde. Having said that, following last Thursday’s policy announcement we feel more confident that attacks on the Euro might be thwarted.