European Central Bank – the _

[2593] OMT; yet another acronym in crisis monetary policy

Yet just another day in the year of crisis monetary policy. And of course, yet another acronym to add to the alphabet soup.

The acronym of the day is OMT. That stands for Outright Monetary Transaction. It is a unlimited but sterilized bond buying program aimed at keep yield of sovereign bonds down, with some conditions, without seniority privilege.

The market is responding relatively well to the OMT but I think the OMT is insufficient to address the woes Europe is facing. The European Central Bank cannot do everything but the monetary policy is a potent firepower nonetheless and I think the ECB has not been using it.

From money supply point of view, the word unlimited is misleading because it is a sterilized operation. That means the ECB can purchase an unlimited amount of bonds, injecting unlimited amount money into the system and then withdrawing the same “unlimited” amount of money from somewhere else. So, any purchase of sovereign bonds by the ECB necessarily means someone else will suffer.

The sterilization is done because Europe, or rather Germany, is so much against quantitative easing, apparently still hung up from inflationary pre-World War II experience.

The sterilization aspect is not different from the previous but defunct program called the Securities Markets Program (the SMP).

It appears to me that the only real difference is the no-seniority nature of the OMT. Then again, as Alphaville at the Financial Times quoted a Mr. Nowakowski, a fixed income strategist at Roubini:

The ECB can promise to be pari passu, until a default threatens and it can then pressure Euritania to let it swap into local or international bonds without CACs that receive special treatment, exactly as it did with Greece. They could still argue, though not in good faith, that those bonds are not senior to anyone, they just got lucky again to get such a great offer. The ECB has tremendous leverage on countries whose banking systems depend on it for funding, so it can call the shots. [Joseph Cotterill. Seniority, the SMP and the OMT. Alphaville. September 6 2012]

So, why again is the market rallying?

[2476] Postponing the European crisis to 2013

I am in the opinion that the expected sovereign debt and banking crises in Europe have been postponed to the end of 2012 or early 2013. There are two reasons why I think so.

The crisis in Europe is essentially two-fold. One is due to government debts. Two is the risk of default by European banks. The two sides are interrelated but it is useful to separate them.

The sovereign debt crisis has been postponed thanks to the establishment and the expansion of the European Financial Stability fund. The EFSF would not be exhausted until the end of 2012 even if all debts repayment or refinancing by the infamous PIIGS (Portugal, Ireland, Italy, Greece and Spain) is financed through facility. The potential rating downgrade of sovereign debts of stronger economies, namely Germany and France, may hurt the likelihood of success of on the EFSF front but I will wait until that actually happens.

I am taking this position because by December 2012, total principal and interest payments made by the PIIGS government is projected to be EUR700 billion. That is below the total size of the EFSF.

The following graph shows principal and interest payment obligation of all the PIIGS government cumulatively. Looking at it, without the more permanent European Stability Mechanism which is supposed to kick start in the middle of next year, trouble will come only around February or March 2013.

The banking crisis meanwhile has been postponed until next year thanks to the soft loan facility provided by the European Central Bank. It has been reportedthat banks in Europe will require EUR700 billion next year to pay up their debts. Since the facility offered by the ECB is at the moment limitless (there will be a limit because already the total loans made by the ECB attract considerable question), the problem on this front too has been postponed to 2013.

This of course says nothing of recession and economic recession is another issue altogether.