The last time Jean-Claude Trichet refused to bow to market pressure, he was forced into a U-turn. This time the stakes may be even higher.
With the euro zone’s sovereign debt crisis now threatening to engulf Spain, its fourth-largest economy, investors are again looking for the President of the European Central Bank to do something to stop it, such as delaying the withdrawal of unlimited liquidity support for banks and significantly ramping up its bond purchases. The risk is that the ECB becomes a bail-out tool for politicians -- damaging its independence -- the very scenario Trichet wanted to avoid when he was pressed into the unprecedented step of buying government debt in May.
“To some extent the ECB is being held hostage by financial markets,” said Juergen Michels, chief euro-region economist at Citigroup Inc. in London. “As the existing measures are unlikely to be sufficient to solve the problems in the periphery, the ECB probably will be forced to increase its programs substantially.”
On May 6, as Greece’s budget crisis was fueling investor concerns about the fiscal health of other euro-area nations, Trichet resisted pressure to employ new measures, saying it was up to governments to lead the way. That lack of action triggered a bond-market selloff, forcing the ECB to tear up its rule book and provoking a split on its Governing Council.
Trichet finds himself in a similar position today after the European Union-led rescue package for Ireland failed to convince investors that policy makers have the tools required, or the resolve needed, to contain the crisis, prompting them to dump Irish, Greek, Portuguese, Spanish and Belgian assets.
ECB policy makers meeting in Frankfurt today will keep the benchmark interest rate at a record low of 1 percent, according to all 52 economists in a Bloomberg survey. That decision is due at 1:45 p.m. and Trichet holds a press conference 45 minutes later.
Bonds, stocks and the euro rallied yesterday as markets interpreted a comment from Trichet as a signal policy makers may step up their response. Trichet told the European Parliament late on Nov. 30 that some investors are underestimating governments’ determination to defend financial stability in the currency bloc.
The euro rebounded above $1.31 to trade at $1.3191 at 12:22 in Frankfurt today. Spanish 10-year government bonds snapped an 11-day drop, sending the yield down to 5.20 percent from 5.50 percent on Nov. 30. That’s still 238 basis points more than the yield on comparable German bunds and close to a euro-era high of 283 basis points.
It would be “more than reasonable” for the ECB to buy Spanish government bonds, Efe newswire quoted Spanish Industry Minister Miguel Sebastian as saying yesterday. He said purchasing debt was “within the orthodoxy” of central banks and the Bank of England and Federal Reserve are following such a policy, Efe reported from Moscow.
Increasing its bond purchases, or resorting to outright quantitative easing by failing to sterilize them, would see the ECB take more risk onto its balance sheet and open itself to the charge it’s financing profligate nations.
Such steps may be resisted by a group on the ECB’s 22- member Governing Council led by Bundesbank President Axel Weber, the leading contender to replace Trichet at the bank’s helm next year.
Weber opposed the bond program when it was announced on May 10 and has since called for it to be cancelled, saying it involves “stability risks” and there’s no evidence it works.
‘A Job For Politicians’
“The risk associated with bond purchases is that the credit risk does not disappear,” said Holger Sandte, chief European economist at WestLB Equity Markets in Dusseldorf. “If the worst comes to the worst, the ECB has all these risks on its balance sheet. It’s really a job for politicians to rescue sovereigns.”
Weber and policy makers such as ECB Executive Board member Juergen Stark are also pushing for the bank to resume its withdrawal of cheap loans to banks as the economy improves. The phasing out of the liquidity measures “will continue” after the end of the year, Stark said on Nov. 16.
The ECB publishes its latest projections today. They may show the euro area’s recovery continuing next year as Germany, the region’s largest economy, prospers from export demand and rising household spending.
Next Exit Step
The ECB currently offers banks as much cash as they need at its benchmark rate for periods of one week, one month and three months. Last month, Trichet said the ECB will announce further steps in its exit from unconventional measures in December due to concerns that banks are becoming “addicted” to the abundant liquidity.
The next likely step in the exit would be announcing a return to an auction procedure for the three-month loans, said Klaus Baader, co-chief euro-area economist at Societe Generale in London. That could limit the amount banks are able to borrow and result in a higher interest rate.
“The ECB is dead set on unwinding measures” so a discontinuation of the full allotment in its three-month refinancing operations “is still likely, although a close call,” said Baader. “They could give a clear date so the decision is taken, but not implemented immediately. That’s a compromise that would be beneficial to all.”
Still, even a move in that direction risks further unnerving investors and exacerbating market tensions, said Ken Wattret, chief euro-area economist at BNP Paribas in London. “If the ECB really goes ahead with the exit or even just signals it will proceed with the exit, it will add to alarm.”
Morgan Stanley economists Joachim Fels and Elga Bartsch said in a research note that there’s a “good chance” the ECB will reverse its exit and reintroduce unlimited 12-month loans to banks.
Saying it will buy more government debt would also calm markets, said Holger Schmieding, chief economist at Joh Berenberg Gossler & Co. in London.
The ECB has already stepped up its activity, last week buying the most bonds in two months. Yesterday it bought Irish government bonds in bigger amounts than it typically does, according to two people with knowledge of the transactions.
Overall purchases so far total 67 billion euros ($88 billion), well below the amounts bought by the Bank of England and the Fed.
“To avoid the risk of a market panic the ECB can do more and should buy more government bonds,” said Schmieding. “If the patient is in danger of a heart attack, a medicine with side effects is justified.”