Divyang Shah, Senior IFR Strategist
Whether it’s repairing the balance sheets of households/financial institutions or the “sustainability of fiscal finances” the BIS argues for a limited role for the central bank.
The BIS makes the point that what central banks have done is to borrow time and this time has not been put to good use. Instead of doing more central banks need to “encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities”. So does this rule out ECB action via the OMT?
The conditionality of the OMT means that it is unlike traditional forms of QE where the lines between fiscal and monetary policy are blurred. The ECB could thus argue that the OMT encourages and complements the adjustment as opposed to delaying it further. However, the underlying message from the BIS is a strong one and this is that central bank actions while justified under a crisis scenario are no longer playing a positive role and by delaying much needed adjustments could be doing more harm than good.
We don’t think the BIS warnings will change the ECB’s attitude toward the OMT, which is more of a deterrent and signal as opposed to an instrument which would be fully utilised. The current price action has, however, supported the view that the peripheral rally seen since Draghi’s comments last year was related more to global liquidity and an extension of excessive risk taking. Now that the QE tide is seen to be going out, eurozone peripheral bond markets are as vulnerable as EM, especially the program countries.
We know Greece will need an OSI, and this won’t happen until after the German elections, but remember both Ireland and Portugal need to start accessing funding markets. The current risk aversion phase in financial markets poses a threat to the desire of Ireland and Portugal to access funding markets, and between the two Portugal seems most at risk. We should see a further widening in the 10-year spreads of Ireland and Portugal as the market prices in the relative risks of the programme countries.
