Unintended Consequences of the ECB Plan

 | Sep 06, 2012 | 5:00 PM EDT
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There are many critically important issues still to be resolved by Europe's fiscal, monetary and government authorities concerning the mechanics of the European Central Bank's plan to cap sovereign yields in the one- to three-year maturity range for Spain and Italy. (I will not address any of those issues here, and let's assume for the purposes of this column that all are resolved and the ECB can actually implement the plan as announced.)

The ECB intends to supply whatever sterilized liquidity is necessary to ensure that sovereign yields in Spain and Italy remain at levels that afford the governments the opportunity to fund ongoing debt commitments and, more importantly, to roll maturing securities into new securities at viable rates. What the governments of Spain and Italy use this money for, and whether or not it stimulates private sector economic activity, will take a few years to realize.

Meanwhile, there is a possibility that the ECB's promise will cause both the supply and demand for short-end securities to increase at the expense of supply and demand for long-end securities. As a result, long-end yields may rise instead of fall under this plan as constituted.

When the U.S. Treasury ended the issuance of 30-year bonds in October 2001, it forced institutional buyers to move down the yield curve to where liquidity was the greatest: the 10-year maturity range. Demand for and trading activity in the residual 30-year bonds shifted to the 10-year note because their ongoing issuance and supply was required to maintain a market for them. In other words, reducing the supply of 30-year Treasuries also reduced the demand for them and for their liquidity, which is an integral part of a functioning sovereign bond market.

Although the U.S. government brought back 30-year Treasuries in 2006, the years in between provide a glimpse of what may occur in the long end of the sovereign markets in Europe as the ECB's plan is implemented. If the governments of Spain and Italy shift toward issuing three-year notes to replace maturing, longer-dated securities as they seek the security provided by the ECB's rate-cap promise, the resulting decline in long-end securities may cause the institutional demand for those issues to wane along with their liquidity. As a result, their yields will increase rather than decrease.

In the U.S., the shift away from the 30-year to the 10-year notes by institutional investors caused yields on 10-year notes to decline, pulling mortgage rates and other capital costs down in the process, thereby stimulating private sector economic activity.

In Europe, the shift may end up being away from the 30-year bonds and 10-year notes to three-year notes. The result may be that yields on 10-year notes in Spain and Italy actually rise and drive up the cost of long-term capital to the private sector, resulting in a decrease in private sector economic activity. We are a long way from this happening, but it is prudent for bond buyers and other capital markets participants to begin to track the issuance, demand and liquidity of long-end European sovereign debt.

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