A shorter version of this text has been published in IPE Magazine

Tomorrow it will be one year since Mario Draghi made his historical speech in London on 26 July 2012 stating that the ECB would to anything in its power to save the euro adding “believe me, it will be enough”.  These statements were soon to be followed early September by the ECB’s decision to introduce Outright Monetary Transactions. These committed it to buying the government bonds of countries which request funding – under the condition that they already have access to capital markets and commit to a fiscal adjustment programme.

What conclusions can be drawn one year later? Did it live up to its expectations or is there reason for disappointment? A useful starting point is to go back to the assessment made on the day of ‘the speech’. On 26 July 2012, I posted a blog describing the implications of Draghi’s comments. In summary, I wrote that the importance of his speech could hardly be overstated. This, very positive reaction, was based on a number of factors as summarised in the following table. I have added a column comparing the expectations at the time with the outcome one year later:

Expectation (based on my blog of 26 July 2012) Outcome

The ECB has found a way of out of the gridlock imposed by the straightjacket of its mandate

OMT can indeed be considered an unconventional monetary policy measure in the context of a mandate which is narrower than the Federal Reserve’s mandate. The decline in spreads shows that we have indeed moved out of the gridlock

The question no longer is whether the ECB will act, but when it will act and how. This change of question should in itself stabilise bond markets, be positive for equities and corporate bonds and support the euro

The ECB acted by introducing OMT yet could stay passive because OMT hasn’t been used yet (because no country requested help). Market reaction was even more positive than expected

The ECB will need to manifest itself quickly to demonstrate that it is serious. Secondary market operations are one of the options

The reaction was quick (OMT was introduced early September). Secondary market operations were not used because the market reaction to the speech and to OMT made it unnecessary

Countries like Spain and Italy will have an easier task in pushing through austerity measures because their bond yields will no longer be rising

Yields not only stopped rising, they declined a lot and this has reduced the sense of urgency. This ties in with a change in the dominating view in Europe that more time should be allowed to bring public sector deficits and debt under control

European leaders can now work in a less tense environment on measures to strengthen the construction which is the eurozone (e.g. European banking supervision, European deposit safety net, broadening the mandate of the ESM)

There has been progress (an agreement has been reached on the Single Supervisory Mechanism) but a lot remains to be done. Moreover, the firepower of the ESM remains limited.

Based on this overview one can say that all in all, Draghi’s comments (and OMT) have lived up to the expectations they created and even went beyond them. Sovereign spreads in the eurozone are lower and equities are up. Bank funding has eased as witnessed by many banks paying back the LTRO funding. The domestic deposit base has improved and Target2 balances have declined. Recent political turmoil in Portugal caused a leap in Portuguese bond yields but the contagion effect to other markets in the periphery was very limited. Credit for this goes to OMT (which in itself was the implementation of the speech made one year ago) but that’s only part of the story. The Fed’s QE policy introduced in September 2012 and Japan’s monetary ‘revolution’ help explain the increase in global risk appetite and the decline in peripheral spreads which has accelerated recently. In a nutshell: QE has pushed investors up the risk ladder and, given that in Europe the ECB had taken the tail risk out of the equation, eurozone assets benefitted strongly from this quest for yield.

On the other hand, in many areas things have not changed or at least not for the better. The state of the real economy has deteriorated: unemployment continues to rise and GDP has been declining for several quarters in a row – though more recently confidence indicators have started to improve. Progress on bringing public finances under control suffers from cyclical headwinds (which in turn are in part explained by fiscal austerity) and credit growth is lacklustre. Also monetary transmission is clogged in the periphery. It would be a mistake to argue that this shows that monetary policy and OMT are ineffective. Where would spreads be in the absence of OMT? Where would the unemployment rate be? What it does show is that there are limits to the effectiveness of monetary policy and that it is not the only answer to all of the problems. This is related to the fact that, as mentioned by Mario Draghi in a recent press conference after the governing council’s meeting, monetary transmission in Europe essentially works via the banking system. Both for demand and supply reasons, this is a slower process than if case capital markets played a bigger role, as they do in the US. Consequently, the recent ECB decision to introduce forward guidance as a new instrument in its monetary toolkit can only be welcomed. However this also serves as a reminder that European financial markets are largely driven by external (= non-European) influences. Forward guidance was introduced to lower the long end of the yield curve after eurozone yields had risen on the back of a similar move in the US (triggered by Fed tapering talk).

Another factor is the drag from fiscal austerity. And of course psychology plays a role: uncertainty about income prospects breeds caution and even households or corporates with enough collateral will refrain from taking on more debt despite the attraction of low interest rates. In summary, this is a long process and a lot of patience will be required. Low rates help but progress on structural topics (Single Supervision Mechanism of the banking sector; economic policy to foster economic growth) is needed as well.
In conclusion, the impact of the “believe me, it will be enough” speech has been huge and has surpassed expectations. Tail risk has largely disappeared. The impact on financial markets has clearly benefited from the boost to risk appetite provided by the Fed’s QE programme. In the real economy, the situation has continued to deteriorate though in the absence of OMT, the situation would be significantly worse.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners
25 july 2013