Europe Saved – But for How Long This Time?

by Jason Jenkins

The European Central Bank (ECB) didn’t buy any sovereign debt a few weeks ago as it terminated its Securities Markets Program (SMP).

ECB President Mario Draghi stated last Thursday, "Following today's decision on Outright Monetary Transactions, the Securities Markets Program (SMP) is herewith terminated."

Draghi went on to state that the ECB will, if necessary, buy sovereign debt in unlimited numbers in an attempt to shore up markets. This had to be done because of all the fears concerning an EU break-up.

But wait, there’s one major condition: If the ECB buys your bonds, you have to fall in line and follow their fiscal guidelines.

The new program is called Outright Monetary Transactions (OMTs). Draghi finished by saying, “This will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.”

That’s a lot of monetary gibberish, so let me translate…

I’ve written many an article on the European Union sovereign debt crisis over the past year. All the countries that got themselves into massive debt problems had issues with adopting austerity measures that some in the EU thought were necessary to get their houses in order. The problem became so serious that some countries’ bonds had unsustainable interest rates that no one wanted to touch. So, something had to be done…

InMay of 2010, the ECB rolled out the Securities Markets Program (SMP). In short, the SMP allowed the ECB to buy sovereign debt in secondary markets to create some liquidity and take some pressure off sovereign debt risk.

In order to curb inflation fears, the ECB introduced a sterilization process that would drain an equal amount of money from the financial system so the money supply doesn’t increase.

Since the program began in 2010, the ECB has spent 214 billion euros on debt from its southern members – most notably the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The program never had full EU support. Germany was never a fan, and it really never stopped sovereign debt rates in those countries from spiraling out of control.

The Outright Monetary Transaction Plan

For more than two years, the entire financial world has been screaming for something to be done. No matter if you sided with austerity or a larger firewall, you knew that the status quo was unsustainable. Many felt that the break-up of the European Union was inevitable. That could mean many EU members returning to their former currency, which would cause fiscal nightmares. It would also almost guarantee another global recession.

About a month ago, Draghi gave us the quote that was heard around the world, “The ECB is ready to do whatever it takes to preserve the euro, and believe me, it will be enough.” Now last week he told us exactly what he meant and he gave us details. So let’s go over some of the more important aspects of the plan.

As we said before, the Outright Monetary Transaction Plan will allow the ECB to buy unlimited sovereign debt with maturities of one to three years. These purchases will also be sterilized.

According to Draghi, the Central Bank won’t have any priority over other bondholders when it comes to OMT purchases. He’s trying to assure private bondholders that they won’t have to carry the weight if there turns out to be some restructuring in the future.

The immediate market response was that the ECB pulled out the big weaponry to fix the sovereign debt crises. Everyone knew that the SMP wasn’t equipped to handle the PIIGS problem as a whole. Now we’re told that there are no limits to what the ECB can do to keep the EU united.

But we’ve heard a lot of things before from EU officials promising a lot that never comes to fruition. Have things changed?

So Have All the Problems Been Solved?

Even after all the hoopla, there’s a lot that can go wrong here. The OMT program is highly complicated and I’m not sure anyone has had adequate time to look over all this. But I think the most important thing to look at in the near future is the coming battle between the ECB and Germany.

It’s interesting that many people aren’t talking about this fact: The German Parliament will essentially have veto power in regards to aid programs countries have to set up before being eligible for the OMT program.

Draghi’s press conference clearly pointed out that any country that wants to participate in the program will have to apply for formal aid from the EU’s EFSF and ESM rescue programs. So countries will have to get approval from other EU members to get their funds for rescue packages. In essence, you still need to beg for German help.

And it seems that Germany is initially not a fan. Jens Weidmann, the German Bundesbank President, has been outspoken to his opposition of the new program.

Here’s something else to keep in mind.

The announcement last week actually stimulated some confidence in sovereign debt. You saw some short-term investors buy back into some bad debt. Let’s see how long the PIIGS ride this bump. No need to implement austerity programs anytime soon if you can ride the wave. Of course this isn’t sound governance – but when has there been for the southern members of the Union?

My gut tells me that this euphoria won’t last long. There are a lot of steps where this can go wrong.

Good Investing,

Jason

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