MacroScope

Draghi’s date with destiny

By Mike Peacock
September 6, 2012

The moment of truth, or at least a moment of truth.

Here’s what we think we know from a number of sources.

Draghi will get broad backing from within the European Central Bank to announce a new bond-buying programme with only Bundesbank chief Jens Weidmann refusing to support it. Draghi will stress the conditions to be attached and the fact that a country must seek help from the euro zone rescue fund in order to keep a lid on internal dissent. 

Details will be somewhat thin on the ground – there will be no statement that it is limited or unlimited (although privately they know they can’t set an upper limit on what they might spend) and no public discussion of setting yield caps above which intervention will be triggered.

But we do expect Draghi to declare the ECB will not be a preferred creditor for any bonds that it buys, in an attempt to stop private investors heading for the exits once the central bank comes in and will say that any purchases will be sterilized if possible, leaving some wiggle room for QE-style money creation in future.

There will be no rate cut, it is barely on the agenda given everything else that has to be nailed down.

Draghi will restate his in camera line on Monday that buying bonds up to a maturity of three years is in line with the ECB’s mandate to ensure the orderly transmission of monetary policy.

That should be enough to  convince markets that something is coming. The big question is whether Bundesbank opposition is enough to dictate an incremental approach from the ECB or if it can go in for “shock and awe” in a way that would give the markets prolonged pause for thought. Ironically, the latter could end up being cheaper than the former.

Recent reports that Weidmann had threatened to resign seem to have been more part of the negotiating and jostling for position than rooted in reality but his concerns will resonate in much of northern Europe. If, for example, Italy elected an anti-austerity government in the spring and looked like it could fall over it’s hard to see how the ECB would withdraw support and watch calamity unfold so, tacitly, it will at least have to be prepared to act without limits and continue to offer support even if its conditions have been flagrantly breached.

The key will be winning the argument that the ECB is operating within its mandate. To that end, Draghi says monetary policy transmission is broken as the ECB has set record low interest rates but Spain and Italy have to borrow at sky-high rates. Because the orthodoxy is that rate changes take two to three years to have their full impact on the real economy, buying bonds of up to that maturity is the right corrective measure. It appears that while there are doubters other than Weidmann on the ECB council, they will swallow hard and back Draghi’s analysis. And crucially, he seems to have Angela Merkel’s tacit support. Last night we had sources in her coalition saying she has pledged her support for Weidmann but one of her key allies also said whatever the ECB was planning was fine as long as it was within its mandate.

This really is a day and a half. Prior to Draghi’s turn, Spain holds its first bond auction for a month, selling two-, three- and four-year paper worth up to 3.5 billion euros. Given the timing, and the market’s reluctance to second guess the ECB it should go okay.

More interesting is likely to be Spanish Prime Minister Mariano Rajoy’s meeting with Angela Merkel in Madrid. He will gauge her support for Spain seeking a bond-buying bailout but has already shot himself in the foot by declaring that he doesn’t expect Spain to have to do anything else on the austerity front in return for help and saying he won’t even ask until the ECB’s plans are clear. That tone is unlikely to help given the imperative on Draghi to prove that tough conditions will be attached.
France has urged Spain to seek aid, maybe because it feels it could dragged down if things drift for much longer, but Berlin has indicated that it wants to see the results of Spanish bank stress tests due later this month before making any decisions.

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