After Mario Draghi, Angela Merkel and Francois Hollande all pronounced that â€œ they would do whatever it takes to save the Eurodollar and the European Union,â€ the EURUSD rallied more than 300 points off the bottom in anticipation of major policy actions. But what can the ECB really do given its limited scope of power?
We examine several options including
Reviving the SMP
Creating LTRO 3
Lowering Benchmark Rates
Moving To a Centralized EU Banking Regulator
Among those actions we conclude that LTRO 3 and lowering benchmark rates will likely has the least impact on moderating rising Spanish bond yields as Mr. Dragi himself has admitted that the â€œtransmissionâ€ mechanism in the EZ is broken as the traditional policy actions have lost much of their effectiveness and the circuitous nature of LTRO has provided only a temporary lift to EZ periphery credit.
We note that reviving the SMP program, which would allow the ECB to support Spanish debt in the secondary market would have some modestly positive impact but would still leave the issue of primary debt a serious problem for policymakers going forward. With the the massive divergence in yields between the Northern European economies and southern European ones characterized by 7% on Spanish benchmark 10 years and negative yields on German 2 years we believe that the situation will become unsustainable if allowed to persist much longer. Finally we note that a centralized EU banking regulator that would provide blanket deposit insurance across the Eurozone would go a long towards pacifying investor sentiment and would temper some of the capital outflows in the region.