Word has it that Mario Draghi is busily working up a new version of his “whatever it takes” methodology. This time the objective is not saving the Eurozone, but maintaining the region’s inflation at or near the ECBs official 2% inflation objective. The first time round the President of the Euro Area’s central bank had it easy, since market participants took him at his word and he effectively needed to do nothing to comply. This time though, as they say, it will be different.



Its getting towards two years now since Mario Draghi made that first famous “whatever it takes” promise for which he will either be feted eternally in the central bankers’ heaven or cursed perpetually in whatever their equivalent of hell is. During that time the tide of the Euro Area debt financing crisis has steadily been turned – perhaps the turning point came when Spain’s prime minister Mariano Rajoy decided not to apply for a full Troika bailout and got away with it, sometime around November 2012.

During the time since that first Draghi promise Spanish (and other periphery) yields have come down dramatically, from around 7% (in Spain’s case) to the current rate of just over 3%. Perhaps the steepest, and most surprising, part of that drop was between January and April 2014, a period in which speculation – often fueled by the ECB itself – was rife that a programme of quantitative easing was in preparation and likely to be launched in order to fend off the threat to Euro recovery presented by low inflation/deflation.

The threat of outright deflation across the entire Euro Area is slight at the moment but, as Mario Draghi himself recognizes, very low aggregate inflation is itself a problem since several countries are bound to have below average inflation, especially those indebted countries on the periphery where domestic demand is weak, capacity slack is large, and there is an ongoing need to recover relative price competitiveness.

Countries like Greece, Portugal, Ireland, Italy and Spain.

Or if you prefer Eastern Europe, Slovakia, Slovenia, or Estonia.

In most of these countries household demand is weak and the economies only grow slowly, leading to a structural demand deficiency. In addition many have enacted labour market reforms whose ongoing impact will be lower average hourly wages. Low inflation is a fact and, if you accept at least some of the above arguments, there is some sort of theoretical backing for the idea that it could weaken further and even fall into deflation in the above countries.

As a result many in the financial markets now assume that Mario Draghi will do “whatever it takes” to restore more robust inflation to the Euro Area, and that this “whatever” will include some version of Quantitative Easing probably including sovereign bond purchases.

The key part of the background here, as Wolfgang Munchau pointed out at the time, is that the recent German Constitutional Court ruling effectively left OMT – which only ever had a virtual existence and was increasingly seen as an empty bluff since it was clear no one was going to accept the conditionality side – deader than that infamous dead duck. Karlsruhe’s objection to Draghi’s original bond buying programme was that it went beyond the ECBs mandate since directly financing government debt is prohibited under Maastricht, and the objective of OMT was to help governments finance at an affordable price. Since break-up risk – which could have offered an alternative justification for OMT – is for the moment off the table, OMT lacks definitive legal justification and in practical terms the emperor visibly has no clothes.

The FT’s David Oakley (February 18) was the first to my knowledge to really join up the dots.



“At last, after resisting for so long, the European Central Bank looks closer to implementing its own version of quantitative easing to spark growth across the eurozone……………… Investors and strategists expect about 30 per cent of the bond buying will be in German Bunds in a €400bn programme. The ECB would then likely buy about 20 per cent in French Oats, 18 per cent in Italian BTPs, 12 per cent in Spanish Bonos, with the rest being bought in the other much smaller debt markets……”





“The German constitutional court has asked the European Court of Justice to make a ruling on outright monetary transactions, which Mr Draghi introduced as a backstop to the eurozone in the summer of 2012. Although outright monetary transactions would involve buying government bonds, it is not the same as QE as it would be introduced in the event of a run on one or more of the debt markets. The ECB could successfully argue that QE, which involves buying a range of bonds to lift inflation, was within its remit as it is designed to bring about price stability…..”

Naturally this debate was a trigger to bring down periphery spreads much further since a blanket sovereign bond purchasing programme (with no conditionality) would be equivalent to some kind of implicit uniform debt guarantee. In addition, a large scale QE programme would – as has been seen in the US and Japan – be supportive of financial assets generally, hence the rush to buy Greek and other bank bonds and shares.

Then there is something called the spread compression trade. Fund managers can make money out of this when bond offer yields that are deemed to be trading substantially out of line with the real risk involved in holding them. I first started becoming aware of this in Europe in the summer of 2012 when investor interest in buying bonds issued by the Catalan regional government (which is effectively locked out of financial markets) surged since the 10 years ones were trading at around 13% in the secondary market. The issue that concerned them was, not the underlying health of the economy, but whether the central government would be able (constitutionally) to rescue the regional ones. At the time there was some doubt among investors, hence the high yield demanded to hold the bonds. But the first to realize that in fact Madrid would rescue the regions (via the Fondo de Liquidez Autonómica, created in the autumn of 2012) could safely buy the bonds sin the full knowledge they were effectively guaranteed. This is what happened, and yields came down, not because the Catalan economy had had a miracle recovery, but because someone else was guaranteeing the debt. At this level its all about perceived risk, not about potential GDP growth or anything like that.

The point to “get” about bonds is that their value moves inversely with yields, so a bond bought with an effective yield of 13% increases its value considerably when the market trades at 6.5%. The gain is conditioned by a variety of factors – maturity, coupon, coupon frequency, starting yield – but a move of these proportions might produce a capital gain of around 50% depending on the modified duration function. This kind of trade effectively involves riding the “spread compression” to make capital gains. It is a trade practiced by more risk prone investors, who then sell the bonds on to more risk averse ones (and take their profits) once the yields are trading at more realistic levels, and the risk is perceived to be reduced.

This is what has just happened with the Greek bond yield.

In July 2013 Greek ten year bonds were trading at something over 11%. For reasons I explain in this post Greece is now something of a special case, since Greek excess debt (anything over 110% GDP in 2022) is effectively guaranteed by the other Euro Area partners. This already meant that Greek yields were trading much higher than the risk warranted, so lots of people started buying simply to squeeze the lemon juice out of the yield compression. Add to this the risk of deflation – Greece is the prime example – and the possibility of QE in the context of Draghi’s “whatever it takes” commitment and Greek bond yields end up having a lot more to fall – 10 year Japanese bonds are currently trading around 0.6% and it is clear the ECB could do the same with Euro Area yields if it really had the will so to do. Lots of gravy swimming on the plate to mop up with some bread then.

The devil is, as always however, in the details. It is not hard for a bright fund manager to convince himself that the governing council of the ECB will one day be forced to implement QE. It is again not that hard for that same fund manager to convince himself that even though the ECB has been toying with a 1 trillion euro asset purchasing program biased towards the private sector, that the market in ABS in Europe is just too small for this to be realistic. But it is pretty hard indeed for him (or her) to decide when the ECB will finally get round to doing it.

Which brings us to the small recent spikes upward to be seen in both the above bond yield charts. Mario Draghi has committed his governing council to doing something at the June meeting, but that something is not likely to be QE. More plausible are things like a small refi rate cut (to 0.1%?) and negative deposit rates. Maybe even some sort of small business lending scheme. But not QE.

Indeed, it isn’t hard to reach the conclusion that what there is consensus on at the ECB governing council at the moment is more akin to the need to lower the value of the Euro than any outright anti deflation policy. Given everything which is happening in Ukraine and the existence of sanctions against Russia German exporters are more than normally squeezed at the moment, so it isn’t that hard to get the Bundesbank on board for some sort of Euro weakening move. But as Reuters’ Ross Finley points out in his “Strong euro may be monster Dragi can’t tame” having at least partially pegged monetary policy to the exchange rate he may now face the prospect of both short-term and long-term investors buying the euro thus making any move he makes somewhat counterproductive.

Finlay’s argument is that if the euro zone economy relapses from its broadening recovery (and there were some signs of this in the Q1 numbers), or inflation remains dangerously low, short term investors may be tempted to try their luck and see how far they can push the euro and peripheral bonds and assets up before a reluctant ECB is forced to step in with a powerful policy response. But if the euro zone economy picks up, and presumably pricing power and inflation with it, flows into euro zone assets naturally will increase and with these the euro will rise. This is why buying Greek bonds isn’t such a foolish think as many conventional analysts thought it was. It could even have been seen (and still be seen) as a kind of one way bet. If things turn out badly then Draghi will do QE, and if they turn out well, well where’s the problem? Either way, these sort of “bets” will keep an upward pressure on the Euro. Once more Draghi is damned if he does and damned if he doesn’t.

Which brings us to another of the wonders of the investment world, the disappointment trade. Those in markets who still expect QE to be introduced in June (is there really anyone out there who still thinks that??) are likely to be disappointed. The result of that disappointment could be a small bond sell-off after the announcement, driving yields temporarily higher. So the savvy investor is now selling some of his/her bonds (take some profits) in order to then buy them back again cheaper sometime after the announcement, and surprise, surprise the euro is (temporarily??) weakening. Could be called the chronicle of a disappointment foretold.

But what then happens? The reason the ECB won’t introduce QE in June, not that there isn’t a need – Wolfgang Munchau has just argued it could already be too late to avoid falling into deflation – but because the Governing Council can’t agree on the need to do it. Indeed with the euro now slipping a bit for the sort of reasons discussed above the Governing Council may even surprise on the downside and do less than expected. But meanwhile that same bright fund manager we spoke of above will conclude that they will get there eventually, that it is only a matter of time (September or December perhaps, depending on the inflation data) and start to buy into the dip in bond values in order to get ready to ride yet another round of yield compression. Naturally when this happens back up the euro will go, confounding policymakers yet one more time.

Wolfgang Munchau suggests that Mario Draghi made a mistake with his original promise. When he said he would save the Euro whatever it takes. Munchau thinks he should have said “Inflation of 2 per cent – whatever it takes”. In a certain sense I beg to differ. The need to eventually implement full blown QE was always implicit, even in the original promise – or at least it was already read this way by a number of very influential investors. Certainly this was the reading Bridgewater’s Ray Dalio put on the promise at the time. The euro “will now ‘likely’ stay together because existing growth-constraining austerity measures will henceforth be balanced by money printing over at the European Central Bank”, he told Bloomberg at the time. (See my “Taking A Man At His Word” post of October 2012 for much more on this).

So now Draghi is about to discover just what it means to enter into an open-ended Faustian pact with people whose motives may be different from yours. All those nice people who helped him hold the Euro together virtually for free now want the other part of the deal. The bond buying/money printing part. Really after these dramatic declines in bond spreads the ECB simply cannot afford NOT to do QE. Opening up the spreads again would be like opening up all those recently healed wounds from the earlier stage of the crisis, and doing it at a time when sovereign debt burdens are much higher. There is simply no way he can do that, and the markets are likely to bet strongly enough that he can’t that this will become a self-fulfilling prophecy.

Oh, yes, there’s just one last question. Will QE work as intended? To get a hold on that problem perhaps it might be worth taking a glance at this piece of mine on Japan – The Real Experiment That Is Being Carried Out In Japan.