Disclaimer

Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. But I can't by law give you advice, and I do make mistakes. Remember: the unexpected sometimes happens. Oddly enough, the expected does too, but all too often it takes longer than you thought it would, or on the other hand happens more quickly than you expected. The Goddess of Markets punishes (eventually) greed, folly, laziness and arrogance. No matter how many years you've served Her. Take care. Be humble. And don't blame me.

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Monday, September 10, 2012

Testing times

Last week, the President of the European Central Bank Mario Draghi ushered in some reforms which will make it much less likely that solvent eurozone countries (as opposed to Greece which is insolvent) will be driven to default.  This week the German Constitutional Court rules on whether the European Stability Mechanism is consistent with Germany's constitution.

Personally, I don't think it's as important as the ECB's agreeing to buy the bonds issued by threatened eurozone members. Although the ECB will only buy the bonds if the country is part of a rescue process approved by the EEC, the European Stability Mechanism is not essential to bailouts.  It does help formalise the process.  But rescues can be cobbled together without it. What the ECB's bond buying initiative does is much more powerful.  In essence it says that if markets drive yields on government bonds to levels which potentially cause a default and therefore a bailout, it will buy the bonds in whatever quantity is necessary to drive their yields down.  In other words, it caps bond yields.  Which means default for a solvent eurozone country becomes very unlikely.   It also means that the banks in those countries can be saved, because they can borrow from the ECB at zero percent and buy their government's bonds at, say 6% and know that the capital loss downside is limited.  And the margin they make can be used to plug the black hole of property losses.  Clever.  The ECB is finally getting a grip of the problem.

See how Spanish bond yields have plumetted since the announcement?



[Chart courtesy of Bloomberg]

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