European policy makers end August with 15 days to justifybondholder optimism that they can deliver lasting solutions to thedebt turmoil.

September offers a microcosm of three years of crisis-fighting.The next two weeks may feature fresh anti-contagion measures fromthe European Central Bank, a possible aid request from Spain andinsight into whether creditors will ease Greece's bailout terms.German judges and Dutch voters also get to proclaim on the euro'sfuture.

At stake is whether politicians and the ECB can extend asummertime shift in borrowing costs by convincing investors Spainand Italy are protected from the rot and the euro is secure. SinceECB President Mario Draghi's July 26 vow to do “whatever it takes”to defend the currency, Spain's 10-year bond yield has fallen abouthalf a point to 6.52 percent, while that of Italy has declined by aquarter-point to 5.81 percent.

“The markets seem to be anticipating progress,” said MickeyLevy, chief economist at Bank of America Corp. in New York. “Whenyou talk to European policy makers, they say we're entering a veryimportant stage.”

The month's main event comes Sept. 6 when Draghi convenes hisGoverning Council, after declaring Aug. 2 that it's “unacceptable”for investors to bet against the euro's future by elevating bondyields. Draghi said that may spur the ECB to buy short-dated bondsin the secondary market, albeit only in concert with directpurchases from governments by Europe's rescue fund, withaccompanying economic conditions.

“Unlimited intervention by the ECB in the bond markets would bethe ultimate game-changer in the euro zone debt crisis,” saidSteven Major, global head of fixed income research at HSBC HoldingsPlc in London. “Not only would it drive spreads down, it would keepthem down.”

Keeping the yields of peripheral nations within a preset rangeof those of core economies could require the ECB to spend as muchas 7 billion euros ($8.8 billion) per week buying bonds, Majorestimates. The gap between two-year German and Spanish bonds couldalmost halve to 200 basis points from more than 370 currently, hesaid.

The ECB “will always act within the limits of its mandate,”Draghi wrote in a commentary for German newspaper Die Zeit providedby the Frankfurt-based ECB yesterday. “Yet it should be understoodthat fulfilling our mandate sometimes requires us to go beyondstandard monetary policy tools.”

Steering Yields

While speculation has mounted the central bank may try to capbond yields outright, Goldman Sachs Group Inc. economist Huw Pillpredicts it will avoid explicit targets for rates or spreads andinstead try to steer market yields within wider bands depending oneconomic performance.

The central bankers may even hold fire. ECB Executive Boardmember Joerg Asmussen said Aug. 27 that the bank shouldn't buybonds before the rescue fund intervenes. Two officials said lastweek it may even hold off furnishing full details of its plan untilGermany's Constitutional Court rules on the legality of theEuropean Stability Mechanism.

So Sept. 12 provides investors with two flashpoints, the Germancourt ruling and a Dutch election. The ESM cannot operate withoutGermany's say so and its 500 billion-euro cash pile is needed ifEurope is to have enough cash to recapitalize banks and supportSpain and Italy.

Joachim Fels, the chief economist at Morgan Stanley in London,says even if the court sanctions the ESM, it may attach conditionswhich limit the German government's ability to pursue deeperEuropean integration in the future. “Given the rise ofeuro-skepticism in Germany and elsewhere, markets would likely takesuch a verdict by the court as a bad sign,” he said.

Jostling for investors' focus the same day is the Netherlandselection. In polls, a third of voters back the Socialists, whooppose more spending cuts and refuse to hand over more sovereigntyto Europe, or the Freedom Party, which seeks an exit from theEuropean Union and the single currency. It could take months for acoalition to be formed.

European finance ministers will meet Sept. 14-15 in Cyprus withGreece, Europe's original problem child, still under themicroscope. After two bailouts totaling 240 billion euros, thenation is struggling to qualify for the next installment, raisingthe risk of a second default and even a possible euro exit.

With his economy plagued by an austerity-driven fifth year ofrecession, Prime Minister Antonis Samaras wants more time to meetthe rescue terms. Possible concessions floated in Germany includefront-loading aid, lowering the interest rate or extendingmaturities on loans and extending debt write-downs to publicholdings such as the ECB's.

The so-called troika — the ECB, European Commission and IMF —return to Athens early next month to study how much of a fundingshortfall Greece faces. While asking for an extension in its fiscaladjustment program by two years to 2016, the government is tryingto show its dedication to the troika's demands by pulling togethera new package of spending cuts for the next two years.

“With some German flexibility, Greece may survive thisSeptember,” said Christian Schulz, an economist at Berenberg Bankin London, who reckons the probability of a Greek euro exit haseased to 35 percent from almost 50 percent earlier this month. “Butthe pressure remains on Greece to take ownership of the reforms anddeliver results.”

ECB Faith

Economists at Citigroup Inc. are less confident, saying lastweek they view a Greek departure in the next six months as“increasingly likely” and possible as soon as next month should thetroika decide the government hasn't done enough. A decision onwhether Greece needs more aid may still not come before October,Luxembourg Prime Minister Jean-Claude Juncker said last week.

The Cyprus talks will also review a first slate of EuropeanCommission proposals to forge a euro region banking union, withcommon supervision for lenders and pooled funds to deal withcrises. The plans, which the Brussels-based commission hasearmarked for publication on Sept. 11, include a draft law to handsupervisory powers to the European Central Bank, a refurbishment ofthe European Banking Authority and a policy paper setting out therest of the banking union project.

Euro area leaders said in June that legislators should study thesupervisory plans “as a matter of urgency.” The commission'sintention is that they would enter into force in early 2013.

Investors may be placing too much faith in the ECB and in theability of governments to soothe their fiscal stresses in a17-nation bloc still lacking economic union, said Neil Williams,head of economic research at Hermes Fund Managers in London, whichoversees about $46 billion.

“There's a bit too much optimism that the euro zone can solveitself in September,” said Williams. “This is going drag into nextyear and beyond.”

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