The European Central Bank needs to back up last week's recordpurchases of government debt with further buying to preventspeculators from driving borrowing costs for Spain and Italy backup again.

“The ECB's bond purchase program has been a very effectivedeterrent to panic selling, and as long as they don't blink now,they can have this problem of speculative shorting licked in weeksrather than months,” said Luca Jellinek, the London-based head ofEuropean rate strategy at Credit Agricole Corporate &Investment Bank.

The ECB snapped a five-month hiatus to buy 22 billion euros($31.7 billion) of government bonds in the week through Aug. 12,and has bought more securities since. That helped push 10-yearSpanish and Italian yields below 5 percent after they surged toeuro-era records the previous week amid concern contagion from thedebt crisis had infected both countries.

The success mirrors the initial benefit of the ECB's firstprogram of buying Greek bonds in May 2010. Policy makers must avoidwhat came after that: a reluctance to extend the program withfurther purchases saw Greek 10-year yields reverse declines andsoar by more than 10 percentage points.

Staying in Play
“They don't need to domassive amounts every week, but they do need to remain in themarket to help stabilize the situation,” said Olaf Penninga, whohelps manage 140 billion euros at Robeco Group in Rotterdam. “Theycould probably get away with a few billion a week if asset marketsremain relatively stable, but they would have to do considerablymore if political tensions arise, like internal disagreement withinthe ECB or opposition to the buying from Germany.”

Ten-year Greek yields initially dropped as much as 468 basispoints after the central bank began 16.5 billion euros of Greekbond purchases last year. Some 14 months later, the yield hadsoared as high as 18.39 percent.

The ECB has overcome internal opposition among its board membersto more bond purchases as bond market moves suggested the region'sdebt crisis was spreading to economies considered too big to rescueby investors.

Italy has the euro-region's largest outstanding debts at 2.1trillion euros, including principal and interest payments,according to Bloomberg data. That compares with 838 billion eurosfor Spain, the fourth-biggest burden in the region.

Funding Costs
Italy's 10-year borrowingcost was at 4.90 percent as of 10:46 a.m. in London, after surgingto a euro-era record 6.40 percent on Aug. 5. Similar-maturitySpanish debt yields 4.91 percent, after touching 6.46 percent onAug. 2, the most since the introduction of the shared currency in1999.

European leaders are struggling to find a solution to the debtcrisis, after a July 21 accord to bolster the region's rescue fundfailed to calm markets. German Chancellor Angela Merkel and FrenchPresident Nicolas Sarkozy rejected an expansion of the 440billion-euro rescue fund on Aug. 16 and rebuffed calls for a commoneuro-area bond, saying greater economic integration was neededfirst.

The two largest euro-area economies will instead push fortougher fiscal debt limits and the establishment of a “eurocouncil” as part of a planned “economic government” for the region,Sarkozy said after the two-hour Aug. 16 meeting with Merkel inParis. Germany and France still share an “absolute determination”to defend the euro, said Sarkozy.

'Only Viable Stopgap'
Dutch FinanceMinister Jan Kees de Jager backed the opposition to a commoneuro-area bond, telling his nation's parliament that while jointlyissued debt was interesting “conceptually,” it would not solve theregion's debt woes.

“In the absence of a sustainable policy solution, ECB buying isthe only viable stopgap,” said Padhraic Garvey, the head ofdeveloped-debt market strategy at ING Groep NV in Amsterdam. “TheECB does not know it yet, but it will find that it cannot step awayfrom its bond buying.”

Purchases may need to be as big as “something approachingforthcoming supply,” according to Credit Agricole's Jellinek.

Italy needs to refinance an average of about 7.5 billion eurosper week in maturing principal and interest payments for theremainder of this year, according to calculations by BloombergNews. That's more than double the weekly average of 3.4 billioneuros for Spain.

“They certainly would need to consider being more active aroundbig supply events,” said Jellinek. “They obviously can'tparticipate at the auctions, but they can help stabilize things bybuying bonds before any coming sales.”

Second Round
The ECB may have spent around12 billion euros in the second week of bond purchases, according toHarvinder Sian, an interest-rate strategist at Royal Bank ofScotland Plc in London.

Concerns about the creditworthiness of euro-area members spreadto France last week, with speculation it may lose its AAA debtrating hammering shares in the nation's banks and sending the riskpremium on its government bonds to a euro-era record. France's toprating was affirmed by Standard & Poor's, Moody's InvestorsService and Fitch Ratings on Aug. 10.

Unprecedented bailouts for Greece, Ireland and Portugal havealready cost 365 billion euros in emergency funding from theEuropean Union, the International Monetary Fund and ECB. That comesas growth in the region slows. The EU statistics office said Aug.16 that gross domestic product rose 0.2 percent in the secondquarter, the least since the region emerged from recession in late2009.

Questions of Safety
“A lot ofinstitutional investors are beginning to question whether Spanishand Italian bonds are stable enough to be included in their bondportfolios, which are meant to be among the safest, most stableinvestments,” said Robeco's Penninga. “New investors need to beattracted to take up the slack. You are only going to attract themwith higher yields. Either way, the ECB still needs to be in thebackground to prevent a return to the recent market turmoil.”

With Merkel and Sarkozy ruling out either an immediateenlargement of the European Financial Stability Facility or thesale of Euro bonds, further debt purchases by the ECB may be theonly defense for Italy and Spain.

“They need to convince the market that if you go short, the guyon the other side is the ECB and they don't lose money, you do,”Jellinek said. “If they really want to win this they can, becausethere's no one big enough to take them on.”

Bloomberg News

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