European Central Bank President Mario Draghi has boxed himselfinto a corner.

Spanish and Italian bond markets rallied yesterday as investorscheered Draghi's signal that the ECB is prepared to intervene toreduce soaring yields. Now he has to deliver, or face deepdisappointment on financial markets, analysts said. The risk indoing so is alienating key policy makers on the ECB council, suchas Bundesbank President Jens Weidmann. The Bundesbank reiteratedits opposition to bond purchases today.

“Draghi is damned if he does and damned if he doesn't,” saidCarsten Brzeski, senior economist at ING Group in Brussels. “Hemaneuvered himself into an extremely difficult situation.Expectations are very high.”

The ECB is under pressure to lower borrowing costs after threeinterest-rate cuts since November failed to stop bond yieldssoaring in Spain and Italy, threatening the survival of the euro.The Frankfurt-based central bank shelved its bond-purchase programin March as dissatisfaction with it among council members grew, andsome economists doubt it will be revived any time soon.

“I don't believe you will see government bond purchases yet,”said Jacques Cailloux, chief European economist at NomuraInternational Plc in London. “But there are other things they cando that will help, such as lowering the haircut on sovereign bondsthey accept as collateral or buying private sector securities.”

ECB policy makers next meet on Aug. 2. They cut the benchmarkrate to a record low of 0.75 percent this month and took the rateon overnight deposits to zero.

Since then, Spanish debt fell 3.2 percent, the biggest declineafter Greece, while French and Austrian bonds delivered the bestreturns in the euro area. Yields on Spanish securities that maturebetween two and 30 years rose above the 7 percent level thatprompted bailouts for Greece, Ireland and Portugal, before plungingafter Draghi's speech yesterday.

“To the extent that the size of these sovereign premia hamperthe functioning of the monetary policy transmission channel, theycome within our mandate,” Draghi said in a speech at the GlobalInvestment Conference in London. “Within our mandate, the ECB isready to do whatever it takes to preserve the euro. And believe me,it will be enough.”

The euro jumped almost 2 cents against the dollar on thecomments and stocks rose. Spain's 10-year bond yield fell as muchas 45 basis points, dropping below 7 percent for the first timesince July 19, and Italy's sank 41 basis points to 6.03 percent.The rally continued today, with Spain's 10-year yield down afurther 12 basis points to 6.81 percent, helped by a report from LeMonde newspaper saying the ECB is preparing to intervene. An ECBspokeswoman declined to comment.

“It will be difficult to hold these gains without any actualaction,” said Christoph Kind, head of asset allocation at FrankfurtTrust, which manages about $20 billion. “There's still pressure onthe spreads of the peripheral countries and I fear this is only atemporary narrowing.”

The ECB is drawing up plans to buy Spanish and Italian debt inthe secondary market in the coming weeks to be followed bypurchases in the primary market by government-financed bailoutfunds, Le Monde said, without citing anyone.

The Bundesbank said restarting ECB bond purchases is not thebest way to address the debt crisis.

“The Bundesbank has repeatedly expressed in the past that itviews bond purchases critically because they blur the line betweenmonetary and fiscal policy,” a spokesman said.

The ECB had limited success the last time it waded into themarket to help Spain and Italy. As bonds tumbled in an earlierphase of the crisis in August last year, the central bank startedbuying their debt for the first time and initially succeeded instemming the immediate turmoil.

Less than three months later, Spanish and Italian yields werehitting new euro-era records as some governments dragged their feeton pushing through new measures to get their budgets undercontrol.

That forced the ECB to turn to unlimited three-year cashofferings as a tool to fight the crisis and it mothballed thebond-buying policy, called the Securities Markets Program.

Spain's two-year yield fell to as low as 2.15 percent on March 1as banks used some of the 1 trillion euros ($1.21 trillion) ofthree-year cash to buy debt, while Italy's reached 1.68 percent. Itproved a short-lived respite.

On July 24, investors demanded 3.69 percent to lend to Spain forsix months. Meanwhile, two-year yields in Austria, Germany, Finlandand the Netherlands fell below zero this month.

'Bazooka'

“We still don't think policy makers have done enough to make themarket sit up and take note,” said Richard Urwin, head ofinvestments at BlackRock Inc.'s Fiduciary Mandate Investment Teamin London. That has left bond yields in weaker countries “too highto be sustainable,” he said.

“The ECB appears to be running out of conventional ammunition,”said Marius Daheim, a senior fixed-income strategist at BayerischeLandesbank in Munich. “What is left, however, is the 'bazooka',” hesaid, referring to large-scale interventions in troubled bondmarkets.

Renewed bond purchases may buy European crisis-fighters time asthey face months of political limbo.

With a Dutch election due in two months and a German courtdecision holding up the start of the permanent bailout fund untilat least September, leaders will find it difficult to makedecisions on issues such as giving Spain a full bailout or findingmore money for Greece.

Still, government bond purchases have seen two German policymakers quit the ECB.

Vocal opponent Axel Weber stepped down as Bundesbank presidentlast year and ECB chief economist Juergen Stark retired at the endof 2011. Both complained that the bond program blurred the linebetween fiscal and monetary policy and relieved pressure ongovernments to enact reforms.

“The Bundesbank has historically been resisting the reactivationof the SMP,” said Julian Callow, chief international economist atBarclays Capital in London. “In the view of most economists, theECB is justified in reactivating the SMP.”

Other options may include allowing the region's bailout fund toborrow from the ECB to buy the bonds of distressed governments. ECBcouncil member Ewald Nowotny said in an interview published July 25that there are arguments in favor of giving the European StabilityMechanism a banking license.

The Bundesbank reiterated its opposition to that proposal todayand Draghi, who has also rejected it in the past, didn't refer toit yesterday.

Either way, “the crisis response looks likely to focus on directintervention in the government bond market,” said Nick Kounis, headof macro research at ABN Amro in Amsterdam. “We have some doubtsabout whether the interventions will be of the required scale. Ittherefore seems likely that the bond purchases will just allowpolicy makers to muddle through unless much more financialfirepower is put on the table.”

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