From the archiveCase study · Jul–Sep 20126 min read
Whatever it takes: Draghi talks Spain down from 7.6%
Two days after Spain’s 10-year yield hit a euro-era record of about 7.6%, Mario Draghi pledged on 26 July 2012 that the ECB would do whatever it took to preserve the euro. OMT followed on 6 September, and spreads fell sharply without it ever being used.
On 26 July 2012, two days after Spain’s 10-year yield hit a record 7.6%, about 640bp over , Draghi pledged the ECB would do whatever it took, within its mandate, to preserve the euro.
Spreads had been pricing a euro break-up. OMT, unveiled on 6 September, offered uncapped, conditional buying of short-dated bonds: Italy’s spread fell from 428bp to 337bp in ten days.
OMT was never used. The lesson still holds: a backstop from a central bank that can create unlimited money can end a self-fulfilling panic, but only once a real tool stands behind it.
The trader’s angle
It is the clearest case of a central bank ending a self-fulfilling panic with words backed by an unlimited tool, and the reason traders still price an ECB backstop into euro-area government bond spreads.
Spain 10-year yield, 24 Jul 2012
about 7.6%
upeuro-era recordIts spread over Bunds hit about 640bp the same day, amid fears that Spain would need a full sovereign bailout.
Italy 10y spread over Bunds
337bp
downfrom 428bp, 4–14 Sep 2012OMT was announced on 6 September. By late December Italy’s spread was around 300bp, with its 10-year yield near 4.4%.
Italian and Spanish 2-year yields
about -2pp
downon the OMT announcementsAn ECB study’s estimate. German and French 2-year yields were unchanged: the backstop removed a risk that only some countries carried.
Spain 10y spread over Bunds, 2 Jan 2015
below 100bp
downfirst time since May 2010From about 640bp at the July 2012 peak, without OMT ever being activated.
A euro-area government borrows in a currency it cannot print. If investors fear it can’t pay, or that it might leave the euro and repay in a new, weaker currency, they demand a higher . The gap over German government bonds (Bunds), the region’s , is its spread, quoted in .
That fear can feed on itself: higher yields make debt harder to finance, which deepens the fear. Part of the spread then becomes a for break-up rather than for the country’s own finances.
A central bank that can create unlimited euros can break the loop by promising to buy, because a buyer with unlimited money can’t be outlasted.
What happened
By July 2012 the euro crisis had reached Spain and Italy. On Tuesday 24 July Spain’s 10-year hit a euro-era record of about 7.6%, roughly 640bp above German government bonds (Bunds), amid fears that Spain would need a full sovereign bailout. Italy’s spread had pushed back above 500bp a few days earlier.
On Thursday 26 July, speaking at an investment conference in London, ECB President Mario Draghi said that, within its mandate, the ECB was ready to do whatever it took to preserve the euro, and that it would be enough. He also signalled that tackling excessive borrowing costs for euro-area governments could fall within that mandate. Spain’s 10-year yield fell back below 7% that day, and Spanish and Italian spreads narrowed sharply over the next two days.
The tool followed on 6 September: Outright Monetary Transactions (OMT).
Why it happened
Spreads that wide were not just about deficits. Investors were pricing the chance that the euro would break up, and that a country might leave and repay its debts in a weaker new currency. That fear fed on itself: higher yields made debt harder to finance, which made exit look likelier, which pushed yields higher still, while money fled to the of Bunds.
A central bank is the one investor that can never run out of its own currency. Draghi’s promise, and then OMT, changed the payoff for anyone betting against Spanish or Italian bonds: they now faced a potential buyer with unlimited money.
OMT’s terms, set out on 6 September: purchases in the of government bonds with one to three years to maturity, no limit on size set in advance, and only for countries that signed up to a programme with the euro area’s bailout funds (the EFSF or ESM) and its strict conditions. The money created would be fully sterilised, or drained back out, and the ECB’s earlier bond-buying scheme, the Securities Markets Programme, was closed.
How it ripples through markets
How a promise broke a self-fulfilling panic
- 1
Break-up fear feeds on itself
upSpain 10y yieldHigher yields make debt harder to finance, so leaving the euro looks likelier and yields rise again.
- 2
Money flees to Bunds
upSpain–Bund spreadHaven demand pushes Spain’s spread to a euro-era record of about 640bp on 24 July.
- 3
Draghi pledges a backstop
downItaly–Bund spread26 July: within its mandate, the ECB will do whatever it takes to preserve the euro. Betting against a buyer that can create unlimited euros looks riskier, and spreads narrow.
- 4
Doubt returns without a tool
upSpain 10y yield2 August: few details, and Spain’s 10-year yield goes back above 7%.
- 5
OMT gives the promise teeth
downItalian and Spanish 2y yields6 September: purchases of 1–3 year bonds with no limit set in advance, for countries that accept conditions. Short-dated yields, on the bonds OMT would buy, fall most.
- 6
Spreads fall without a purchase
downItaly–Bund spreadWith an unlimited buyer in reserve, betting on a break-up stops paying and that premium drains out: Italy’s spread is around 300bp by late December, and OMT is never used.
Why it mattered for traders
The front end moved first. OMT was aimed at short-dated bonds, and Spain’s steepened sharply as traders bought them ahead of the announcement. An ECB study later found the OMT announcements cut Italian and Spanish 2-year yields by about 2 percentage points, while German and French 2-year yields were unchanged.
The road was not smooth. At its 2 August meeting the ECB gave few details, and Spain’s 10-year yield went back above 7%. A promise moves markets, but a promise without a tool fades. And the haven trade reversed: on the day of the speech, Bunds fell as demand for the safest assets eased.
The lasting change was the ECB’s : it would now stand behind government bonds in a panic, on conditions. Much of what had been in Spanish and Italian spreads was a for break-up, and a credible backstop drains it.
What happened next
OMT was never activated, yet spreads kept falling. Italy’s spread dropped from 428bp on 4 September to 337bp by 14 September. By late December it was around 300bp, with its 10-year yield near 4.4%. Spain’s fell below 100bp on 2 January 2015, for the first time since May 2010.
The programme was challenged in Germany’s Constitutional Court, which referred the case to the EU Court of Justice. In June 2015 that court ruled that a programme like OMT did not exceed the ECB’s powers or breach the ban on monetary financing of governments, and the German court accepted it, with conditions, in 2016. The promise was never tested, and that was the point.
Academy lessons for this story
Was this explanation clear?
Test yourself
Finishing the quiz adds the story’s key facts to your review deck.
Sources
- Bank for International Settlements (central bankers’ speeches) — Verbatim of the remarks made by Mario Draghi at the Global Investment Conference, London, 26 July 2012
- European Central Bank — Technical features of Outright Monetary Transactions, 6 September 2012
- European Central Bank — The financial and macroeconomic effects of OMT announcements (Working Paper 1707)
- Court of Justice of the European Union (via BAILII) — Gauweiler and Others, Case C-62/14, judgment of 16 June 2015
- European Central Bank — The benefits and costs of asset purchases (speech by Isabel Schnabel, 28 May 2024)
- Bloomberg — Spanish Yield Exceeds 7% as Bunds Jump After Draghi Disappoints
- Última Hora — El Ibex despide los 6.000 puntos por primera vez desde abril de 2003 (Spanish risk premium record, 24 July 2012)
- Fiscal Focus — Btp, spread su Bund in calo a 337 pb (14 September 2012)
An original summary written from the sources above. Figures are rounded; follow the links for the full record.
Keep reading