Euro-area leaders granted immediate respite to the stressed bond markets of Spain and Italy, leaving investors looking to the European Central Bank to provide more lasting relief.
By addressing flaws in their bailout programs, moving toward a banking union and trying to break a negative-loop between troubled sovereigns and banks, officials today triggered the biggest rally in Spanish bonds and the euro this year.
Whether the gains are extended may depend on the willingness of ECB policy makers to next week reward political progress with greater crisis-fighting steps of their own. Governments must also avoid their past mistake of declaring victory too soon as investors press them to move faster on binding the 17-nation euro region more closely together.
“The ball is very much in the ECB’s camp,” Gilles Moec, co-chief European economist at Deutsche Bank AG in London, said in an interview with Bloomberg Television. “The statement creates an environment in which it makes it easier for them to take more unorthodox decisions.”
Stocks jumped along with Italian bonds after 13 1/2 hours of talks ended with leaders paving the way for cash-strapped lenders to tap Europe’s bailout fund directly once they establish a single banking supervisor. Until now, they had to get aid through their governments, piling pressure on already beleaguered national coffers. The ECB will play a role in the new supervisory body, officials said.
The euro’s guardians also agreed to drop a requirement that taxpayers get preferred creditor status on emergency loans to Spanish banks. Other steps included agreeing to use rescue funds to stabilize markets in certain conditions.
The euro surged the most this year against the dollar, riding as much as 1.6 percent to $1.2628. Spain’s 10-year yield plunged 41 basis point to 6.528 percent after hitting a euro-era record of 7.29 percent on June 18. The MSCI All-Country World Index climbed 1.3 percent to 306.82.
The measures are aimed at luring investors back into markets and breaking a vicious circle in which the woes of the banks reinforced those of the sovereign and vice versa, fanning a crisis which this week claimed Cyprus as its fifth victim. They also aim to sooth bondholders spooked by the terms of a Spanish banking bailout that sapped the feel-good factor created by Greece’s election of a pro-bailout coalition government.
“If we never had the issue of seniority for bailout funds, and if we had created direct bailouts for banks ages ago, perhaps that would reduce the scale of the crisis,” said Kit Juckes, head of foreign exchange research at Societe Generale SA in London. “The damage to international confidence in European bonds has been done and won’t easily be repaired.”
Attention now turns to the ECB, which has acted following political progress before, buying bonds after the establishment of bailout programs in 2010 and giving banks unlimited three-year loans following last year’s pledge to deliver fiscal discipline.
“I am actually quite pleased with the outcome of the European council,” ECB President Mario Draghi told reporters in Brussels today. “It showed the long term commitment to the euro by all member states of the euro area.”
Draghi, who refused to take questions, chairs the ECB’s next policy meeting on July 5 amid speculation officials will lower their benchmark interest rate by at least 25 basis points to a record low 0.75 percent as the economy hovers near recession. They may also cut their 0.25 percent deposit rate in a bid to discourage banks from parking excess liquidity at the ECB.
As well as providing some economic support, lower interest rates would also help embattled lenders in the so-called periphery by making the central bank’s emergency loans cheaper.
An unresolved issue is whether Europe’s permanent bailout fund, due to come into force in July, will get a bank license that would allow it to tap the ECB. That would help ramp up the power of a kitty currently dwarfed by the size of the bond markets that leaders want them to rescue, allowing it to buy debt in an “unlimited and indefinite fashion,” said Marchel Alexandrovich, an economist at Jefferies International Ltd. in London.
Currently, the bailout funds have 500 billion euros at most available to them. Italy and Spain have about 2.4 trillion euros combined of outstanding bonds, bills and loans.
The central bank still needs to do more than cut rates, said Holger Schmieding, chief economist at Berenberg Bank. Policy makers may back a third round of long-term loans as soon as next week and “if we’re lucky” restart their controversial bond buying program, he said. Further chaos in markets may persuade it to eventually act to cap yields given the bailout funds do not have the capacity to beat back investors for long, he said.
“If the summit result encourages the ECB to step in with serious support for sovereign bond markets, it could be a smashing success,” said Schmieding. “If the ECB holds back instead, the crisis could possibly escalate badly over the summer until the ECB finally relents.”
For Moec, the enhanced supervisory role envisaged for the ECB may make the central bank happier to act, even though leaders didn’t make much progress on the fiscal union that Draghi has been pushing.
“Offering the ECB the possibility of looking at what banks do is a huge step forward for them,” he said. “The ECB may be put off by the fact that there was no clear discussion on fiscal integration and debt mutualization. But at the margins it helps the ECB to make the right decision.”
The ECB may still hold off on delivering more than lower borrowing costs as its officials want to keep pressure on governments to act and feel liquidity is ample at the moment, said Michael Schubert, an economist at Commerzbank AG in Frankfurt. They are also against resuscitating their bond-buying program given that it neither solves fiscal weaknesses nor helps insolvent banks, he said.
The onus also remains on leaders to ultimately match monetary union with fiscal union, said David Mackie, chief European economist at JPMorgan Chase & Co. Even as she was forced to make concessions on easing aid terms for Spain and Italy, German Chancellor Angela Merkel succeeded in keeping the central issue of euro bonds off the summit’s agenda.
Shared loan liability would likely require new euro-wide laws in which Germany would surrender its opposition to aiding neighbors with unsustainable debts in return for a willingness by the cash-strapped nations to accept more budget oversight.
“Reaching agreement on the road map to fiscal union will be challenging and there is then the thorny issue of the national ratifications of a new treaty,” said Mackie.