ECB Watch - The new anti-fragmentation tool: five lessons from the SMP

Plan A in our view very much focuses on PEPP reinvestments. In the last Governing Council policy statement it committed that ‘in the event of renewed market fragmentation related to the pandemic, PEPP reinvestments can be adjusted flexibly across time, asset classes and jurisdictions at any time. This could include purchasing bonds issued by the Hellenic Republic over and above rollovers of redemptions…’.Potentially, the Governing Council could signal it will already start to skew reinvestments towards capping fragmentation, with a particular focus on Italy and Greece. However, the size of reinvestments – even assuming a significant skew towards peripheral sovereign bonds - means that this plan may not ultimately be successful. The ECB’s Plan B might be the announcement of a new purchase programme aimed specifically at fragmentation. A reasonable analogue might be the Securities Markets Programme, launched by the ECB in 2010 with the aim of capping spreads to ensure the transmission of its monetary policy. A look at the SMP provides five lessons about any new tool: 1 - The SMP was employed when the 10y spreads of the bonds of the targeted jurisdictions were in excess of 300bp 2 - The SMP was sterilised so that it had no impact on the monetary policy stance. This is a limitation on the size of the programme, because there are limits to how much of the liquidity can be absorbed. Overall under the SMP, around EUR 220 bn of bonds were acquired between 2010 and early 2012, which is quite modest compared to the peak periods for the PEPP and APP. 3 - The bonds purchased under the SMP had senior status. This undermined the effectiveness of the programme. Subsequent programmes, including the OMT shifted to equal status and we think that is likely with any new tool. 4 - The ECB did not announce detailed modalities on the SMP, in terms of maturities or size. 5 - The SMP had a significant impact on spreads after announcement but it was ultimately unsuccessful. Hence it was replaced by the OMT, which probably was durably effective because markets speculated that QE would eventually come into place. Overall, the ECB may well focus in the near term on reinvestments. Subsequently, we could see a new tool. However, the odds are that it will be sterilised, which could limit its size.