July 28, 2012

Sceptics abound as Mario Draghi's ECB bond 'bluff' electrifies global markets

The European Central Bank has opened the door to emergency support for the Spanish and Italian bond markets, setting off a blistering rally on bourses across the world.


Mario Draghi, the ECB president, vowed to do "whatever it takes" to save the euro within limits of its mandate."Believe me, it will be enough," he said in London.

Picking codewords instantly understood by traders, Mr Draghi said the violent spike in bond yields in recent days was hampering "the functioning of the monetary policy transmission channels" - the exact expression used to jusfify each of the ECB's previous market interventions.

Yields on Spanish two-year debt plunged 72 basis points to 5.47pc in barely an hour, with comparable moves on Italian debt - easing the pressure before a string of debt auctions in Rome over coming days. The MIB index of stocks in Milan surged by 5.6pc.

Madrid's IBEX rose 6pc, the biggest jump in two years, led by an explosive rise in bank shares. Mr Draghi's comments came as Spain claimed backing from France and Germany for activation of the eurozone's rescue fund (EFSF) to buy Spanish bonds, though this would require calling the Bundestag's finance committee back from holiday for a vote.

Action by the EFSF would provide "political cover" for the ECB to join the fray in a two-pronged attack. "We're firing on all cylinders: that is what has ignited the markets," said Hans Redeker, currency chief at Morgan Stanley.

Joint statements from Madrid, Paris and Berlin said market turbulence "does not reflect the fundamentals of the Spanish economy, or the sustainability of its public debt". The wording seems scripted to clear the way for intervention.

The euphoria is unlikely to last long unless the ECB comes through with concrete action after its pre-holiday meeting next week. Angel Gurria, head of the OECD, honed in on Mr Draghi's caveat, saying the legal constraints are the nub of problem.

The ECB must "explore the flexibility of its mandate", he said. Others were blunter. Marc Ostwald from Monument Securities said Mr Draghi's words were "cheerleading bluster", while Gary Jenkins from Swordfish called them "a bluff to get through the summer".

"Spain is very close to the precipice, and its pretty much game over already, " said Mr Jenkins. "Today's action was a short-covering rally.

The real trick is get bond investors to come in alongside the ECB, and that is much harder." Markets have become sensitive to the risk of "subordination" after the ECB and other EU bodies refused to take losses on holdings of Greek debt.

Private creditors suffered bigger haircuts as a result. Mr Jenkins warned that the purchases of Spanish and Italian bonds risk setting off further capital flight unless the ECB makes it "contractually clear" that it does not have senior status.

"Investors will just try to get out," he warned. Critics say the ECB's pin-prick purchases of Greek, Irish, Portuguese, Spanish and Italian bonds have fallen between two stools: enough to create subordination fears, without being enough to eliminate the risk of sovereign default. It would now take massive intervention by the ECB to repair the broken trust.

Any such move would risk a showdown with the Bundesbank and its hawkish allies in the Teutonic bloc. "German resistance has risen over the past several months," said Nicholas Spiro at Spiro Sovereign Strategy.

The International Monetary Fund has called for full-blown quantitative easing (QE) - with purchases across eurozone states - to lift the eurozone out of deepening slump. This would not breach the ECB's mandate.

Mr Draghi shelved the bond purchase programme shortly after taking charge last November, opting instead for a €1 trillion blitz of cheap lending to bank - a less obvious violation of the "no bail-out" clause of the Maastricht Treaty.

While this so-called "LTRO" scheme bought a few months' calm over the winter, the effect has worn off. Data released by the ECB on Thursday showed that lending to households and business contracted by €88bn in between April and June.

LSE Professor Tim Congdon said the chief cause of Europe's credit crunch is the EU policy of forcing banks to raise core Tier 1 capital ratios to 9pc too fast.

"Loans are shrinking because of a misguided regulatory assault. It is crazy to make banks shrink risk assets in a recession," he said.

The LTRO has left a host of problems in its wake, and is unlikely to be part of Mr Draghi's next set of tricks. RBS says Spanish and Italian banks have "parked" funds in sovereign bonds that have since plummeted in value.

These lenders may have to crystalize large losses as they draw on the money to roll over their own debts.

Angus Campbell from Capital Spreads said it will take a radical change to the ECB's legal mandate before Mr Draghi can deliver on his words.

"Until European politicians can agree to the necessary treaty changes, we could see this rally fizzle out as quickly as it materialised," he said. Meanwhile, Moody's downgraded Sicily's issuer and senior unsecured ratings to Baa3 and said it could cut it further.

telegraph.co.uk

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