Draghi turns back the tide – for now

Posted on July 27, 2012

Mario Draghi proved something this week: central bankers can still turn the tide in stressed financial markets – at least temporarily. With a few words on Thursday, the European Central bank president reversed a surge in Spanish and Italian borrowing costs that had taken the eurozone debt crisis to a higher level of intensity.

The ECB was ready to do whatever necessary to preserve the euro, “and believe me, it will be enough”, he told a London conference ahead of the Olympic games. If bond risk premiums hampered the effectiveness of ECB monetary policy, “they come within our mandate”, he added.

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    But Mr Draghi’s verbal intervention was also a sign of weakness: unconvinced by efforts so far to shore up Europe’s 13-year old monetary union, investors are pushing eurozone governments for faster and more aggressive action – and the ECB to mull policy options, including revamped, larger-scale asset purchase schemes, that its president had hoped would remain locked away in Frankfurt filing cabinets.

    Mr Draghi’s comments have “bought time” until the ECB’s governing council meeting next Thursday, says Steven Major, global head of fixed income research at HSBC. “Then there had better be something substantial, and in order for the ECB to be doing something, it will be pushing for the politicians to show evidence of progress on reform too.”

    What is likely to have alarmed Mr Draghi was a sudden spike early in the week in Madrid and Rome’s two-year borrowing costs. Triggered by worries over the indebtedness of Spanish regions, yields on the country’s two year bonds on Monday saw their biggest jump since the eurozone debt crisis first erupted in early 2010 and hit an intraday high of more than 7 per cent on Wednesday.

    Whereas 10-year bond yields grab the headlines, the leap in two-year yields is more relevant when it comes to immediate financing needs. The yield profile, and hopes that economic reform programmes could turn investor confidence within a few years, has encouraged crisis-hit governments to borrow over shorter periods. As Stephane Deo, global head of asset allocation at UBS, says: “The market is getting closer to the governments.”

    Although ECB longer-term refinancing operations in December and February, which saw it lending more than €1tn in three-year funds, allowed banks in Spain and Italy to step up bond purchases, the effects could be fading: ECB data this week showed Spanish banks’ holdings of government debt, which soared in the first part of the year, have fallen since April, albeit modestly.

    Meanwhile, negative yields on German bonds may reflect more than a global hunt for havens. In paying to lend to Berlin, investors may be betting that the value of their holdings will increase in the event of a eurozone break-up leading to a redenomination into D-Marks.

    Mr Draghi’s comments brought relief, but also scepticism. “It remains to be seen whether Draghi was signalling a new policy initiative or simply restating the mandate of the ECB,” warns Mohamed El-Erian, chief executive of Pimco, one of the world’s largest bond investors. “The analogy I heard recently in Europe is that of a dog – ie, the markets – at the end of a leash held by policymakers. Sometimes the dog pulls you along, sometimes you have to pull the dog back.”

    Instead, the financial markets want “game-changing” action. Andrew Milligan, head of global strategy at Standard Life Investments, says: “The eurozone is falling into a Japanese-style trap by saying: let’s give ourselves more time and not take radical decisions that have to be taken, for instance on labour market reform in Italy or bank restructuring in Spain.”

    He adds: “With all these worries about the US and China as well as Europe, the case is building for co-ordinated and unified action by major central banks.”

    For the ECB, the most obvious option would be a revival of its “securities markets programme” to buy Spanish and Italian bonds. But its experience of using the SMP exactly a year ago – when Spanish and Italian yields were also surging – is inauspicious; the ECB ended up in an unseemly squabble with Rome over Italian reform measures, and the crisis simply intensified.

    Another market-favoured option would be to grant the European Stability Mechanism, the continent’s new bailout fund, a banking licence, enabling it to leverage itself with the ECB’s unlimited liquidity supplies – something Mr Draghi has categorically ruled out in the past.

    Beyond that, investors are looking for faster progress on clearing up Spain’s banking problems, possibly by imposing losses on senior bondholders, and towards a stronger eurozone banking and political union. “It is difficult to know precisely what measures would be taken but I think there will be some kind of debt mutualisation,” says Mr Deo at UBS. “I think that’s inevitable.”

    The risk is of Thursday’s ECB meeting disappointing. But Mr Draghi has at least dispelled the idea of ECB idleness. Perhaps wisely, he told Le Monde newspaper this week that he never planned holidays ahead “and I only ever go away for a few days”.

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