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"Moral hazard 101" with professor Draghi

This is a syndicated repost courtesy of Sober Look. To view original, click here. Reposted with permission.

The ECB has been quite clear about focusing their bond buying on the short end of the curve (see this discussion). There has been some speculation that Draghi will only buy short-term bills, but we got some clarification today. The ECB will target the short end of the curve of up to 3 years.

Bloomberg: – European Central Bank President Mario Draghi told lawmakers he’d be comfortable buying bonds with maturities of up to about three years, said Jean-Paul Gauzes, a member of the European Parliament.

Purchasing short-dated bonds doesn’t constitute state financing, Draghi said during a closed-door parliamentary session in Brussels today, Gauzes told reporters afterwards. “He thinks it’s not a violation of the treaty and you can do it under the current legal framework,” Gauzes said. “He said for example three years is ok, 15 years no.”

Of course it’s not “state financing” because that would be outside of ECB’s mandate. Right.

The market is reflecting just such a policy with the Spanish sovereign curve staying quite steep at the short end. This policy is basically the reverse of what the Fed has been trying to do via Operation Twist.

Spain’s sovereign curve – now and 2 months ago (Bloomberg)

When the bond buying program is in place, this “reverse Twist” will become easy pickings with low risk for hedge funds. Traders will buy bonds just outside the three year range and wait for them to roll down the curve. They are going to capture the relatively high income as well as the capital appreciation from the rapidly declining yield as the maturity shortens with time. And once the bonds are within the range, there is a “free put option” from the ECB who will not permit yields from rising above a certain levels.

We all know what happens when central banks provide a free put option (such as lowering rates every time the housing market sneezed during the boom years in the US – see this chart for example). Welcome to “moral hazard 101” with professor Draghi.

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