Draghi Risks Market Wrath as Pressure for ECB Action Grows
Whatever Mario Draghi does today, economists say doing nothing is not an option.
Investors are looking for the European Central Bank President to make good on his promise to do whatever is needed to protect the euro, interpreted by most as a signal that the ECB will intervene in bond markets. Should Draghi fail to overcome the objections of Germany’s Bundesbank to such action, the disappointment could spark a selloff. He holds a press conference at 2:30 p.m. in Frankfurt.
“If Draghi just comes out with a do-nothing, markets are going to react extremely badly and the ECB will have a full- blown crisis on their hands,” said James Nixon, chief European economist at Societe Generale SA in London. “I can’t see what form of words Draghi can come up with that would replace concrete intervention.”
Investors and politicians are clamoring for ECB action to quell Europe’s sovereign debt crisis, which is threatening to cripple Spain and Italy and tear the 17-nation euro area apart. While Draghi’s commitment in London last week to do what’s needed fueled a global market rally, some economists cast doubt on his ability to build the consensus needed to deliver a game changer.
The euro advanced 0.3 percent to $1.2257 at 9:49 a.m. in Frankfurt and the Stoxx Europe 600 Index (SXXP), Europe’s benchmark equity index, rose 0.2 percent.
ECB officials meeting in Frankfurt will keep the benchmark interest rate at a record low 0.75 percent, according to 51 of 55 economists in a Bloomberg News survey. Four predict a cut to 0.5 percent. The deposit rate will be left at zero, another survey shows. The decision will be announced at 1:45 p.m.
The Federal Reserve yesterday pledged to take new policy steps as needed to promote stronger economic growth and employment. The Bank of England will today hold its key rate at 0.5 percent and maintain its bond-purchase target at 375 billion pounds ($586 billion), surveys of economists show. That decision is due at noon in London.
An estimate of future average overnight borrowing costs in euros, the three-month Eonia OIS swap, dropped to a record low of 5.4 basis points yesterday, Bloomberg data show, suggesting traders have increased bets on the ECB cutting rates further.
The problem is that the central bank’s rates aren’t influencing market borrowing costs as investors dump the sovereign bonds of Spain and Italy amid concerns about their credit-worthiness. While markets rallied on Draghi’s pledge to act, Spain’s 10-year bond yield, at 6.73 percent yesterday, is still 536 basis points above Germany’s.
“To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate,” Draghi said in a speech in London on July 26. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Having fueled expectations to such an extent, “Draghi is hardly likely to want to appear empty-handed,” said Christoph Balz, an economist at Commerzbank AG in Frankfurt. “But none of the options are easy to implement. Perhaps Draghi will pull a new rabbit out of the hat.”
In the past week, he has canvassed support among ECB council members and politicians for a multi-pronged approach to reduce soaring bond yields, two central bank officials with knowledge of the discussions said on July 27.
Draghi proposes that Europe’s rescue fund buy government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its interest rates, the officials said on condition of anonymity. Further ECB rate cuts and long-term loans to banks are also up for discussion as the euro economy slides toward recession, one of the officials said.
While the leaders of Germany, France and Italy have appeared to endorse Draghi’s plan, echoing his language in saying they will do whatever is necessary to protect the euro, significant hurdles remain.
For the rescue fund to buy sovereign debt, the government in question must make a formal application, and any aid would carry conditions. Spain has no intention of making such a request, Treasury head Inigo Fernandez de Mesa said July 30.
“Draghi therefore finds himself in an awkward position,” said Ken Wattret, chief euro-zone economist at BNP Paribas SA in London. “Either he will disappoint market expectations relative to what was said last week or alternatively, the ECB will have to fly solo and re-start the SMP.”
The ECB’s bond-buying instrument, the Securities Markets Program, has been dormant since March.
The day after Draghi spoke in London, the Bundesbank reiterated its opposition to ECB bond purchases, saying they blur the line between fiscal and monetary policy. Draghi planned to hold talks with Bundesbank President Jens Weidmann this week in an attempt to find common ground, the two central bank officials said.
The ECB shouldn’t overstep its mandate, Weidmann said in a June 29 interview posted on the Bundesbank’s website yesterday. Weidmann will attend today’s ECB council meeting, a Bundesbank spokesman said.
“A paper currency is only ever as good as the credibility the public attaches to it, and if these disagreements spill out like this it is damaging to the euro,” said Julian Callow, chief international economist at Barclays Capital in London.
Another option is for the ECB to purchase bank and corporate bonds to ease financing conditions, said Huw Pill, chief European economist at Goldman Sachs International in London. Pill expects the ECB to allow national central banks to buy such assets at their own risk, which would “offer scope for surgical interventions targeted to address the most impaired elements of monetary policy transmission,” he said in a note to clients on July 29.
Policy makers could also decide to offer banks another batch of long-term loans, known as Longer Term Refinancing Operations. Bond yields declined after the ECB flooded markets with more than 1 trillion euros ($1.23 trillion) of cheap three- year loans in December and February as banks in Spain and Italy used the funds to purchase the debt of their governments.
“The ECB has been emphasizing that it has yet to evaluate the full impact of the previous LTROs, making another one less likely in the short term,” said Athanasios Vamvakidis, head European currency strategist at Bank of America Merrill Lynch in London. If it does opt for such a measure, the bank may have to complement it with looser collateral requirements, he said, adding that lowering haircuts on asset-backed securities could free up as much as 100 billion euros of additional collateral.
Economists said one grand solution to the crisis is unlikely to be announced today: giving Europe’s permanent bailout fund, the European Stability Mechanism, a banking license. That would allow the 500 billion-euro ESM to borrow from the ECB, boosting its firepower.
“A banking license for the ESM or open-ended purchases of government bonds would violate the ECB’s prohibition of deficit financing,” said Tobias Blattner, an economist at Daiwa International in London. “This is likely to be one of the most important press conferences in the short history of the ECB. But market expectations have gone well beyond realism.”
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