The European Central Bank will need to commit more to its Italian and Spanish bond purchases than it did trying to cap the yields of Greece, Ireland and Portugal.
Last week’s decision to end an 18-week fast and resume buying Irish and Portuguese debt wasn’t unanimous, ECB President Jean-Claude Trichet said at a press conference that coincided with the resumption. Bundesbank President Jens Weidmann was among the dissenters, according to an official familiar with the discussions. The Aug. 7 statement heralding the extension of support to Italy and Spain was issued in Trichet’s name.
Italy’s 10-year borrowing cost declined by 81 basis points to 5.3 percent yesterday, the biggest one-day drop since the euro was introduced in 1999, after reaching a record 6.4 percent last week. Spain’s 10-year yield has shed 110 basis points in the past week. Both yields have declined by an additional 20 basis points today. The European Financial Stability Facility must be “effectively and rapidly” overhauled to provide additional firepower, European Union financial services commissioner Michel Barnier said yesterday.
“Whether this will restore confidence is another big question,” said Nick Firoozye, head of interest-rate strategy at Nomura International Plc in London. “Oftentime, the ECB showed it’s not that committed. Not all ECB members supported this intervention. The market will need long-term solutions to back this up and they are still missing. It’s still unclear what will happen to the EFSF and there’s still doubt if the new measures will solve the Greek solvency problem.”
The ECB started snapping up Italian and Spanish bonds yesterday, after Standard & Poor’s lowered the U.S. rating by one level to AA+ with a negative outlook on Aug. 5. Speculation about that downgrade, combined with concern that the global economy is stalling, pushed the extra yield investors demand for holding 10-year Italian and Spanish debt instead of German bunds to euro-era records last week.
“The buying of Italian and Spanish bonds is a risky strategy,” said Charles Diebel, the head of market strategy at Lloyds Bank Corporate Markets in London. “For it to work, the ECB will have to be very committed. Given the amount of reticence -- the fact that the decision was not unanimous and the ECB’s view this is not their job -- the market will soon test its resolve.”
Finland’s Prime Minister’s Jyrki Katainen said Europe’s best bet to escape the debt crisis threatening to engulf Italy and Spain is to implement measures already agreed immediately instead of searching for new tools.
The ECB began the bond-buying program on May 10 to stabilize markets rocked by the sovereign-debt crisis. That didn’t protect Ireland and Portugal from following Greece in requesting financial aid from the EU and the International Monetary Fund, and Greece from securing a second bailout last month.
The central bank has spent 74 billion euros on the program, which paused from March. Analysts at Royal Bank of Scotland Group Plc estimate that 850 billion euros ($1.2 trillion) of bonds might need to be bought.
Yesterday’s purchases helped to narrow the yield spread between Italian and German debt to 302 basis points after reaching a euro-era record of 416 on Aug. 5. The yield difference between Spanish securities and German bonds pulled in to 289 after rising to a record of 418 last week.
Gains in Italian and Spanish bond prices may prove short-lived as investors seek to offload their holdings, said Luca Cazzulani, a senior fixed-income strategist at UniCredit SpA in Milan.
“Investors will probably not forget that so far the ECB buying has worked only temporarily, and has been the prelude to a fully fledged bailout,” said Cazzulani. “They may be tempted to sell into strength. The ball is now back in governments’ hands.”
Purchase Program Performance
The yield on two-year Greek notes has risen 22 percentage points, or 2,200 basis points, since the ECB started its bond-purchase program. Portuguese 10-year yields have more than doubled at 10.63 percent in the same period, while Irish 10-year borrowing costs have climbed 447 basis points to 9.88 percent.
The ECB’s bond purchases also failed to cap increases in the cost of buying default insurance. Credit-default swaps on Greek debt increased to 1,657 basis points from 617 when the ECB initiated its support. Default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent, should a borrower fail to pay its debts.
Analysts at UniCredit estimate that the central bank may have to buy as much as 10 percent of outstanding debt over a longer period of time, possibly more than 30 weeks, to be successful. Italy has the most debt outstanding in the euro region. Its debt combined with that of Spain is nearly double the 1.2 trillion euros owed by Germany, according to data compiled by Bloomberg.
The ECB may be reluctant to boost its market support on concern the purchases may stoke inflation by increasing the money supply, said Mohit Kumar, head of euro-region and U.K. interest-rate strategy at Deutsche Bank AG in London.
Trichet last week reiterated the ECB’s tough stance on the need to curb rising prices even as investors scaled back bets on the central bank adding to its two rate increases this year. The ECB held its benchmark rate on Aug. 4 at 1.5 percent.
The central bank has warned the region’s governments that they must convince investors they will curb deficits and pay their debts on time. Italy must prove it can implement fiscal reform, while Spain had to push ahead with plans to recapitalize its banks, said Deutsche Bank’s Kumar.
“What the ECB is trying to do is to prevent the liquidity problem from becoming a solvency problem,” said Kumar. “In the end, the success of this intervention depends on Italy’s and Spain’s ability to prove to the market this is not a solvency issue.”