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  • flashcrashcoming flashcrashcoming Aug 31, 2012 8:15 AM Flag

    Draghi’s ‘convertibility’ fears set ECB tough task

     

    Draghi’s ‘convertibility’ fears set ECB tough task
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    By William L. Watts, MarketWatch
    FRANKFURT (MarketWatch)—European Central Bank President Mario Draghi is fighting a battle against fear itself.

    Draghi’s pledge at a July investment conference in London to do “whatever it takes” within the ECB’s mandate to preserve the euro grabbed headlines. But the rationale he laid out to justify extraordinary action has received less attention.

    The ECB chief has effectively vowed to take aim at the extra premium demanded by investors to hold certain European government bonds that can be attributed purely to fear the euro could fall apart. That, however, potentially leaves the central bank with an unenviable analytical and strategic task, economists said.

    “What are the precise determinants of a [yield] spread? This is devilishly difficult to ascertain,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a London-based consulting firm.

    The risk inherent in holding, say, a 10-year Spanish government bond is typically measured by comparing its yield to a “risk-free” benchmark, such as 10-year German government bonds, or bunds. The difference between the two yields is the spread.

    Draghi has argued that the large premiums demanded by investors to hold certain euro-zone government bonds reflect not only typical spread drivers such as default risk or concerns about liquidity, but are also driven by fears about “convertibility.”

    In other words, investors are reluctant to hold certain government bonds because they’re afraid the issuer could leave the euro, redenominating the debt in a new and likely much weaker currency. That fear is manifested in the extra yield that investors demand on top of other premiums to hold those bonds.

    Moreover, that fear-stoked premium means that when the ECB cuts interest rates, the easier lending conditions that are supposed to ensue don’t arrive in places like Spain or Italy, rendering the ECB’s monetary-policy moves ineffective. That is what Draghi is talking about when he says the transmission of the ECB’s monetary policy has been compromised.

    And that is why Draghi contends it is within the ECB’s narrow, price-stability mandate to rectify the situation by taking action—buying bonds—to eliminate that convertibility premium.

    That potentially leaves a couple, not-so-small challenges: determining just how big that convertibility premium is, as well as how to best make it go away.

    Speculation, fueled by numerous news reports, has mounted over how the ECB will go about implementing any new bond-buying plan. These include setting either explicit or secret targets or ranges for bond yields or for yield spreads.

    But such an approach would require the ECB to determine what it thinks is the appropriate risk premium for Spanish, Italian or other government bonds.

    “Who is the ECB to decide the appropriate spread levels?” said Piet Lammens, fixed-income strategist at KBC Bank in Brussels.

    Grant Lewis and Tobias Blattner, economists at Daiwa Capital in London, note that attempts at determining the added risk premium “are subject to a large degree of uncertainty” and vary according to what economic model is used.

    In an exercise using a recent Federal Reserve study of the yield curve, the economists estimated that the average “excess risk premia” priced into Spanish and Italian 10-year-bond yields—based on the latest European Commission economic forecasts—stood at around 1.4 percentage points and 0.9 percentage point respectively

    Sentiment: Strong Sell

    This topic is deleted.
 
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