WEEKLY COMMENTARY: Mario Draghi’s Verbal Intervention

Last week, we cautioned against fatigue with the Eurozone playing the same record over and over again. This week, the tune changed. At a conference in London, European Central Bank (ECB) President Mario Draghi gave what seemed to be a remarkably forceful speech. While his performance in the Q&A after past ECB meetings had already demonstrated a willingness to be quite direct, the speech he gave at the Global Investment Conference on July 26 was still much more strident than anyone was expecting. Two comments in particular fired the imagination:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough,” and;

“To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.”

The conclusion seems clear. “[W]hatever it takes” is a phrase without ambiguity. Additionally, wide spreads—that is, high yields in the periphery—are a legitimate target for ECB intervention under the guise of ensuring that the current 0.75% repo rate is properly transmitted to the affected economies. It follows then, that Draghi has communicated that the ECB will not stand on the sidelines dogmatically allowing the Eurozone to unravel, and consign itself with it to oblivion. This has long been FFTW’s belief, but it is worth restating due to the number of people who have taken a very literal approach to the Treaties.

In response, spreads have tightened very sharply. The Chart of the Week, for the second time in a row, shows 10-year Spanish yields, which have rallied by 85 basis points over the week to Friday July 27, to 6.66%. The move is even more pronounced at the front end, where the rally has been in excess of 160 basis points.

What makes this even more remarkable is that at the time of this writing, rumors are circulating that Spain will enter a program with the International Monetary Fund (IMF) and the European Union (EU), which has been vociferously denied by Spain’s Deputy Prime-Minister, Soraya Saenz de Santamaria. The way to square the circle, of course, is that some support is much better than no support.

However, we should caution against being carried away by exuberance. What did Draghi really tell us that we did not already know? He told us that the ECB can be much more creative in the implementation of its core monetary policy function than some had presumed. Yet the ECB invented both the SMP (Securities Market Programme)—by which it bought bonds of peripheral issuers, and also the Long-Term Refinancing Operation (LTRO) and its successor, by which the feedback mechanism between banks and sovereign issuers was, if not broken, then at least significantly weakened. Most recently, the ECB cut the rate it pays on reserves to 0%. Despite some perceptions, the ECB has form with doing “whatever it takes.” It must follow though, that behind the very direct language, Draghi was reiterating what we already knew and not announcing anything truly novel.

What was also not new were the other aspects of his speech, which focused at some considerable length on the importance of combating debts and deficits. It was made very clear that Draghi regards progress in this sphere as essential. The ECB is not going to reward back-sliding. However, this raises a significant issue. If yields are where they are not due to liquidity or fundamental break-up fears—because the ECB can and has addressed both of these—then that leaves the reason for a risk premium as solvency. There are fewer quick fixes for that.

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