In the first week of September the European Central Bank lit the EUR/USD on fire with its latest acronym to save the euro â€“ OMT, short for â€œOutright Monetary Transactions.â€ For most investors, OMT is just another ingredient in the central bankâ€™s alphabet soup which already includes SMP, EFSF and ESM, but this one has been enough to drive the EUR/USD to a 4 month high. If you are wondering just why economists and investors are so excited, read on because in our education center, we always attempt to explain relevant concepts in a simple manner.
Lets start by breaking the words down:
Outright â€“ An outright program pertains to a program that is open, direct and without restrictions
Monetary – Monetary basically refers to providing money or funds
Transactions â€“ Through â€œTransactionsâ€ or deals in the market
For the ECB in particular, these outright monetary transactions involve buying government bonds in the secondary bond market. Hereâ€™s the way it works:
Step #1 â€“ Country X admits that it has a problem and needs help by officially asking the European Union or the International Monetary Fund (IMF) for help.
Step #2 â€“ EU and/or IMF agree to help and lay out the deficit reduction terms that Country X must abide by. There are 2 programs that would qualify. Program 1 is a â€œfull macroeconomic adjustment program,â€ similar to what Portugal, Ireland and Greece have. Program 2 is a less stringent â€œprecautionary programâ€ which is like a line of credit and would be terms more agreeable to a country like Spain or Italy.
Step #3 â€“ Country X agrees to the fiscal reduction program and ECB moves forward with buying short term bonds (3 years or less) of Country X to keep yields and borrowing costs low, making debt service more manageable for the country.
1. Unlimited Purchases – OMT is unlimited, which means that the central bank would provide an open ended commitment to continue buying the countryâ€™s bonds as long as they continue to adhere to terms. OMTs replace their previous SMP or Securities Market Program which was limited and temporary
2. Sterilization - Bond purchases will be sterilized which means they will fully offset their purchases by selling other securities such as Treasury bills to neutralize the impact on money supply. By doing this, the ECB avoids going down the path of quantitative easing which involves creating new money
3. Seniority - Draghi said the ECB will be â€œpari passuâ€ with other creditors. Pari passu is a Latin phrase that basically means on equal footing so effectively the central bank will be giving up its seniority to convince bond holders that if they invest in highly indebted nations, in the event of a default or debt restructuring the ECB will not stand in front of them in line to be repaid.
Will this be enough to save Europe?
Probably not. The ECB is still using monetary tools to solve fiscal problems. What Europe really needs is major fiscal change in the form of a real fiscal and banking union along with a convincing plan to promote growth.