Draghi Boxes Himself Into a Corner

"Damned if he does and damned if he doesn’t"

By Jana Randow and Lukanyo Mnyanda 

Spanish and Italian bond markets rallied yesterday as investors cheered Draghi’s signal that the ECB is prepared to intervene to reduce soaring yields. Now he has to deliver, or face deep disappointment on financial markets, analysts said. The risk in doing so is alienating key policy makers on the ECB council, such as Bundesbank President Jens Weidmann. The Bundesbank reiterated its opposition to bond purchases today.

“Draghi is damned if he does and damned if he doesn’t,” said Carsten Brzeski, senior economist at ING Group in Brussels. “He maneuvered himself into an extremely difficult situation. Expectations are very high.”

The ECB is under pressure to lower borrowing costs after three interest-rate cuts since November failed to stop bond yields soaring in Spain and Italy, threatening the survival of the euro. The Frankfurt-based central bank shelved its bond- purchase program in March as dissatisfaction with it among council members grew, and some 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 Nomura International Plc in London. “But there are other things they can do that will help, such as lowering the haircut on sovereign bonds they accept as collateral or buying private sector securities.”

Rate Cuts

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

Since then, Spanish debt fell 3.2 percent, the biggest decline after Greece, while French and Austrian bonds delivered the best returns in the euro area. Yields on Spanish securities that mature between two and 30 years rose above the 7 percent level that prompted bailouts for Greece, Ireland and Portugal, before plunging after Draghi’s speech yesterday.

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

Euro Jumps

The euro jumped almost 2 cents against the dollar on the comments and stocks rose. Spain’s 10-year bond yield fell as much as 45 basis points, dropping below 7 percent for the first time since July 19, and Italy’s sank 41 basis points to 6.03 percent. The rally continued today, with Spain’s 10-year yield down a further 12 basis points to 6.81 percent, helped by a report from Le Monde newspaper saying the ECB is preparing to intervene. An ECB spokeswoman declined to comment.

“It will be difficult to hold these gains without any actual action,” said Christoph Kind, head of asset allocation at Frankfurt Trust, which manages about $20 billion. “There’s still pressure on the spreads of the peripheral countries and I fear this is only a temporary narrowing.”

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

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

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

Limited Success

The ECB had limited success the last time it waded into the market to help Spain and Italy. As bonds tumbled in an earlier phase of the crisis in August last year, the central bank started buying their debt for the first time and initially succeeded in stemming the immediate turmoil.

Less than three months later, Spanish and Italian yields were hitting new euro-era records as some governments dragged their feet on pushing through new measures to get their budgets under control.

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

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

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

‘Bazooka’

“We still don’t think policy makers have done enough to make the market sit up and take note,” said Richard Urwin, head of investments at BlackRock Inc.’s Fiduciary Mandate Investment Team in London. That has left bond yields in weaker countries “too high to be sustainable,” he said.

“The ECB appears to be running out of conventional ammunition,” said Marius Daheim, a senior fixed-income strategist at Bayerische Landesbank in Munich. “What is left, however, is the ‘bazooka’,” he said, referring to large-scale interventions in troubled bond markets.

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

With a Dutch election due in two months and a German court decision holding up the start of the permanent bailout fund until at least September, leaders will find it difficult to make decisions on issues such as giving Spain a full bailout or finding more money for Greece.

Bundesbank Stance

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

Vocal opponent Axel Weber stepped down as Bundesbank president last year and ECB chief economist Juergen Stark retired at the end of 2011. Both complained that the bond program blurred the line between fiscal and monetary policy and relieved pressure on governments to enact reforms.

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

Other Options

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

The Bundesbank reiterated its opposition to that proposal today and Draghi, who has also rejected it in the past, didn’t refer to it yesterday.

Either way, “the crisis response looks likely to focus on direct intervention in the government bond market,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “We have some doubts about whether the interventions will be of the required scale. It therefore seems likely that the bond purchases will just allow policy makers to muddle through unless much more financial firepower is put on the table.