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ECB May Upset Markets With Small Bond Buys, Daiwa Says

The European Central Bank may disappoint investors by limiting the size of potential bond purchases and may force Spain and Italy to sign a memorandum of understanding, according to Daiwa Capital Markets Europe.

“Contrary to the expectations of many market participants, we do not think the ECB will announce an interest-rate or spread target for short-dated peripheral government bonds” and may “announce a volume of future bond purchases instead,” London-based Daiwa economists Tobias Blattner and Grant Lewis said in a note to investors published today.

ECB President Mario Draghi said on Aug. 2 that the central bank may buy government debt in unison with the region’s bailout funds to address elevated yields that are “related to fears of the reversibility of the euro.” Chancellor Angela Merkel yesterday backed the ECB’s insistence on conditions for helping reduce borrowing costs, saying Germany is “in line” with the central bank’s approach to defending the euro.

Still, while Draghi has pledged that any intervention “will be enough,” the Daiwa economists say that if “the past is any guide, the ECB could aim small,” referring to the central bank’s two covered bond-purchase programs that were limited to 4 percent and 6 percent respectively of euro-area outstanding covered bonds.

Daiwa reckons that if the ECB were to aim for Spanish and Italian maturities of up to three years, mirroring the length of the loans it pumped into the banking system, a 15 percent volume target would result in purchases of 30 billion euros ($7 billion) of Spanish bonds and 78 billion euros of Italian debt, reflecting the relatively longer average maturity of Italian and Spanish government bonds.

‘Pale in Comparison’

A 15 percent volume target is similar in size to the U.S. Federal Reserve’s second quantitative-easing program. Even if the ECB were to top that by buying a third of all outstanding Spanish and Italian government bonds with a residual maturity of less than five years, the 340 billion-euro bill would “pale in comparison” with the ECB’s 1 trillion-euro longer-term loans, according to the report.

The central bank is reluctant to opt for a spread target, because the “the potentially unlimited bond purchases such a move could imply are, in the ECB’s opinion, simply not compatible with the prohibition of monetary financing of government debt in the EU Treaty,” Daiwa said.

To further ensure that countries don’t deviate from the path of revamping their economies, “the ECB might require a separate memorandum of understanding between itself and the country concerned, underpinning the conditional nature of its bond purchases,” Daiwa said.

For Italy, that may prove too much, the report said, as “with most Italian political parties already positioning themselves for elections in April next year, they are unlikely to want to pre-commit to yet more austerity and structural reforms, which would likely prove an electoral liability.”

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