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Friday, August 24, 2012 11:29 PM

Interest Rate Caps vs. Bands: Can "Secret Sauce" Make a Difference?

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One day after the ECB warns people to not speculate on interest rate caps, the ECB throws fat into the fire causing speculation on interest rate bands.

Reuters reports ECB mulls setting target bands for bond yields

The European Central Bank is considering setting yield band targets under a new bond-buying program to allow it to keep its strategy shielded and avoid speculators trying to cash in, central bank sources told Reuters on Friday.

Setting a band is an option gaining in favour among central bankers, but the decision would not be made before the ECB's September 6 policy meeting, the sources said.

"That is one of the options that is currently being discussed in the working groups and will then be handled by the Governing Council," a euro zone central bank official told Reuters on the condition of anonymity.

"That is the most likely approach, and also the one that could be most successful."
Secret Sauce?

Supposedly "Keeping the intervention target secret could give the ECB an element of surprise and make it more difficult for investors to try to second-guess the bank."

Quite frankly, that's ridiculous, especially over the long haul.

Here's the deal. If the ECB sets the upper bounds of the bands too low, there will be unlimited supply willing to sell to the ECB and the ECB's balance sheet will reflect that fact.

Can This Work?

Let's review what I said in ECB Considers Interest Rate Caps; Can Such a Scheme Possibly Work?
Theory vs. Practice

The ECB can "in theory" defend a price target on bonds, but only at the risk of owning every bond.

What about an exit mechanism? How will the ECB get rid of all those bonds down the road? To who, at what price?

Will Germany go along with this ridiculous scheme? For how long?

As is always the case, interference in the free market by central planning fools always fails in the long run.
Market Forces Will Eventually Rule or ECB Will Be a Proud Buyer of All Bonds

A band may briefly slow down or speed up price discovery, but eventually (and way sooner rather than later) the ECB, will be forced to defend the band if it is way out of line from normal market forces.

Note that the concept of a lower bound is complete silliness. Will the ECB really act to force up rates in Spain and Italy if the rate is deemed to be too low? If not, the lower band is zero and the upper band is the only pertinent issue.

Whatever the band is, if the upper interest rate band is too low, the ECB will be the proud buyer of 100% of the bonds of Italy and Spain. Thus the idea that interest rate bands offer a meaningful improvement over rate caps is total nonsense.

Neither bands nor caps will work in practice. However, if the upper range is high enough where genuine buyers would step in on their own accord, then a cap or a band could conceivably appear to work.

Mike "Mish" Shedlock
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