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ECB Said to Buy Bonds of Italy, Spain to Cap Gain in Yields

President of the European Central Bank Jean-Claude Trichet
President of the European Central Bank Jean-Claude Trichet. Photographer: Hannelore Foerster/Bloomberg

The European Central Bank bought Italian and Spanish government bonds amid concern their rising bond yields may force the two countries to seek bailouts, according to six people with knowledge of the transactions.

The ECB later bought Irish and Portuguese bonds, said two of the people, who asked not to be identified because the deals are confidential. The ECB said last night it will “actively implement” its bond-purchase program, signaling it is ready to start buying Italian and Spanish securities to counter the sovereign-debt crisis. A spokeswoman for the central bank declined to comment today.

“I don’t think Italy and Spain are insolvent, but the problem they are facing now is a lack of buyers in a highly risk-averse environment,” said Peter Schaffrik, head of European interest-rate strategy at RBC Capital Markets in London. “They need an official buyer to replace the eroding buyer’s base for now.”

The ECB may have spent more than 10 billion euros ($14 billion) buying peripheral bonds, with purchases “heavily concentrated” in Italian bonds, according to Ciaran O’Hagan, the head of European interest-rate strategy at Societe Generale SA in Paris.

Bond Yields Slide

The yield on 10-year Italian bonds fell as much as 82 basis points to 5.26 percent today, the biggest one-day drop in yields since the euro was introduced in 1999. The yield difference between Italian debt and German bunds narrowed to 303 basis points after reaching the euro-era record of 416 basis points last week. Spanish 10-year yields slid 88 basis points to 5.16 percent as of 5:58 p.m. in London.

ECB President Jean-Claude Trichet detailed the steps Italy must take to overhaul its economy in a letter sent late last week to Prime Minister Silvio Berlusconi, Corriere della Sera reported today.

The letter, also signed by Bank of Italy Governor Mario Draghi, urged the Italian government to speed up asset sales, including local state-owned companies, and to liberalize the labor market by making it easier to fire full-time private- and public-sector employees, Corriere said. The steps were to be carried out in exchange for the ECB buying Italian bonds, the Milan daily said.

ECB Buying

With governments failing to act swiftly enough to stop contagion from Greece’s fiscal meltdown, it has fallen to the ECB to battle a crisis that’s now threatening the survival of the euro. Buying Italian and Spanish debt may require the ECB to massively expand its balance sheet and open it to accusations of bailing out profligate nations, breaching a key principle in the euro’s founding treaty. Germany’s Bundesbank opposes the move.

The ECB began the bond-buying program on May 10, 2010, to stabilize markets rocked by the region’s fiscal crisis. That didn’t stop Ireland and Portugal from following Greece in requesting financial aid from the European Union and the International Monetary Fund, with Greece receiving a second bailout last month.

The ECB paused its program from March until Aug. 4. The central bank’s bond purchases differ from so-called quantitative easing policies pursued by the Federal Reserve and Bank of England because the central bank mops up the liquidity created by the purchases, meaning the net effect on the money supply is neutral. The move is aimed primarily at reducing volatility in the market.

‘Markets Fragile’

The buying of Italian and Spanish bonds by the ECB came after Standard & Poor’s lowered the U.S. one level to AA+ on Aug. 5 while keeping the outlook at “negative” as it becomes less confident the country will be able to reduce its spending.

The credit rating cut, combined with concern that the global economy is stalling, prompted investors to flee high-yielding assets in favor of havens.

“Financial markets are already fragile on weak and vulnerable growth prospects, particularly in the advanced economy,” Societe Generale analysts including Stephen Gallagher in New York wrote in an e-mailed note on Aug. 7. “The S&P move is not good news. Brace for turmoil in next few days or weeks and a negative reaction for risk assets.”

Stocks fell around the world, with the MSCI World Index slumping 3.4 percent.

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