The contest is at hand and the crowd is baying for blood. ECB president Mario Draghi is the matador, and Spanish debt is the bull - and quite the chunk of steak. Spain’s borrowing costs just keep on rising, hitting a record high of 7.6% on 10-year yields last week. The bailout of the Spanish banking sector may have delayed economic collapse by a few weeks, but now el toro is back, stamping its hooves, and poised to charge. Now Draghi, with his assembled ECB banderilleros and picadores must decide how best to slay the beast.
Draghi said earlier this week that the Bank would do ‘whatever it takes’ to save the euro. His comments prompted a stock market rally of epic proportions – Madrid’s IBEX closed up 6% that day. But now all eyes are on the president to see if he puts his money where his mouth is. And action is in short supply these days: the US Federal Reserve and UK Monetary Policy Committee have both opted for a 'sitting on hands' strategy in recent days. UK interests rates have been kept at 0.5% and quantitative easing has been shelved indefinitely.
The ECB has a number of options. It can restart its Securities Markets Programme and use it to buy Spanish bonds in large quantities in order to artificially distort market rates. But this isn’t really Draghi’s style – the last SMP purchase took place in January, and he has been reluctant to commit to any more, saying it’s up to governments to help themselves.
Alternatively, it could simply lend Spain the money it needs outright. Small problem, however: the ECB is forbidden from lending money to European governments under its constitution. And, if it wants to tweak the rules, it’s going to need full support from its funders. Germany, the richest nation on the ECB’s books, has already made its opposition clear: Bundesbank president Jens Weidmann said last month that the ECB is required to ‘respect, and not overstep, its own mandate’. Eins zu null für dich…
Another possibility is that the ECB will attempt to avoid the wrath of Germany by simply acting as an agent for bailout funds, and dispense cash from the European Financial Stability Fund (EFSF) or the planned European Stability Mechanism (ESM), to buy bonds directly from eurozone governments. However, there are issues there too. In order to borrow from the ECB, the ESM needs a banking license. These are rare as hen’s teeth, and Dutch finance minister Jan Kees de Jager has already put the kibosh on the idea, saying that allowing the ESB to borrow ‘increases the risk of moral hazard’.
So what did Draghi decide? Alas, the ECB seems to have fallen victim to the same funk that's plagued the MPC and the Fed. Far from outlining a solution, Draghi has simply said that the Bank will unveil a solution 'over the coming weeks'. It plans to buy bonds, apparently, but not through the SMP. Instead, the ECB will focus on short-term bonds (so the Germans aren't shackled to long-term debt). This was hardly the fatal blow to Spain's borrowing crisis we were hoping for.
Earlier today, Nicholas Spiro of Spiro Sovereign Strategy said: ‘If the ECB's policy announcements later today prove to be a disappointment, Spanish and Italian bonds are likely to come under renewed selling pressure. As far as the markets are concerned, the ECB is the only institution that can credibly counter a collective loss of confidence in Spain and Italy.’ How right Spiro was. After Draghi's press briefing, the Spanish and Italian stock markets fell sharply with borrowing costs across both countries rising sharply. The yield on Spanish 10-year bonds rose from 6.6% to 6.9%, while Italian bond 10-year bond yields rose from 5.7% to 6.2%.
It's a disappointing result from the man who promised to do 'whatever it takes' to save the euro. The world hoped that the ECB president would get his silks on, sharpen his lance, and spear Spain's debt through the heart. The reality was more Death in the Afternoon.