The remarkable thing about this morning’s 3 month t-bill auction is how unremarkable it was. The whole thing seems to have gone off without a hitch. Happy days. We’re not back in the bond markets just yet, but it is a good first step towards a return to business as usual.
An article by Amartya Sen in the Guardian on European economic policy – link here
Today the NTMA announced Ireland will resume treasury bill auctions, the first since September 2010. This is a really good thing.
But this does not mean Ireland is “back in the bond market”, with all the baggage that phrase has for Irish people these days. We’re back in the Bill market. Journalists in particular should understand the difference between bonds and bills.
While both bonds and bills are debt obligations, in other words when you buy either a bond or a bill you are lending your money to the Irish government, and both are auctioned, bills are used as short term liquidity instruments, typically repaying the bill buyer in 3 months or 6 months or something like that, while bonds carry much longer maturities, usually 2 years, 5 years, 10 years, even 30 years, and are typically used to pay down other maturing bonds or to finance state expenditure. See these lecture notes, slide 218 in particular, for more details. Update: these ones are way better.
Thus Bills differ in their form and their usage, it doesn’t make sense to confuse them. While today’s announcement is a good sign, we shouldn’t get too excited over their issuance. Portugal has been issuing T-Bills throughout its time as a programme country, and even Greece got some away in May.
For these reasons we shouldn’t read too much into the yield and bid to cover ratios of these bills. It’s still a positive first step, but it’s not Ireland dipping its toes in the water of the markets, more like us taking off our socks near the pool.
Twenty years ago this summer, Europe’s currency arrangement, the ERM, began to tear apart. Fixed exchange rates last as long as the markets fear that central banks can out-buy the sellers. The Bank of England ran out of reserves in September, making George Soros famous, and the system broke up in the middle of 1993. There was no buyer of last resort for the weaker currencies.
Under EMU the sovereign bond market plays the role of the forex market. There is no buyer of last resort for the weaker sovereign bonds. The unwillingness of the ECB to play this role means that Spain and Italy can be forced out of the market. Their total bond stock is approaching €3 trillion. Ongoing deficits and rollovers mean their gross issuance could not conceivably be financed by official lenders.
So they must be kept in the market or the crisis enters the endgame. The ECB has suspended its SMP (Securities Market Programme) which bought sovereign bonds in the secondary market. It pursued this programme in half-hearted fashion, worrying in public about the quality of the bonds it was buying. Sterling would have crashed out of the ERM more rapidly if the Bank of England had gone around bad-mouthing the quality of the sterling it was supporting back in 1992.
Selling sterling to the Bank of England, if the latter possessed unlimited reserves, would have been a mug’s game. Selling Spanish or Italian bonds to somebody with unlimited stocks of Euros would be suicidal.
The Brussels summit has opened the way for the ESM to buy bonds in the secondary market, so the ECB has been replaced with a buyer whose balance sheet constraint is known. This is actually a retrograde step. The ESM could quickly become Bank of England Mark II if a sizeable bond market run re-emerges.
Nobody in their right mind will short an asset into the Central Bank against money. They cannot run out of the stuff. Nobody can operate a credible reverse tap in the Spanish and Italian bond markets except the ECB, or some agency with unlimited facilities at the ECB.
Some useful decisions were taken at Brussels last week but the crisis will persist until this central issue is addressed. Spain and Italy cannot pay more than 4%, or maybe 4.5%, and retain debt sustainability. A reverse tap operated by the ECB places credit risk on its balance sheet and extends the moral hazard (liberally available to European banks) to Mediterranean governments. So the fiscal compact must be implemented and the political commitment problems resolved.
The devil is never in the details. The devil is in the principles.
While the euro zone leaders’ summit certainly exceeded expectations, the shift from dire pessimism to elation in the Irish press reaction over the last few days seems overdone. The big question across numerous articles seems to be how much of the €63 billion put into the banks will now be mutualised. Unfortunately, I don’t see anything in the post-summit statement that leads me to revise a view that the chances of other European countries absorbing already crystallised losses in the Irish banks are approaching zero – the “similar treatment” statement notwithstanding. More positively, the chances of beneficially refinancing the promissory notes/ELA arrangement looks to have increased, which (depending on the details) could lead to a large NPV benefit, and thus significantly reduce the burden of banking-related debt. While this might partly explain the fall in bond yields, my guess is that the majority of the fall reflects a decline in the chances of a major euro zone crisis following financing difficulties in Italy and Spain. Excessively hyping what has been achieved runs the risk of later disappointment, undermining support for unavoidable adjustment efforts.
Another worry is that the triumphalism on display following the summit runs the risk complicating German politics on risk sharing. Thus far, the German government has moved incrementally, slowly bringing a sceptical electorate along with them. The perception that “Merkel blinked” could lead to a backlash.
So, yes, Friday morning brought some very welcome news. But there remains a hard slog ahead.