Monday, August 8, 2011

Meanwhile, the ECB Commits Overnight to Buying Italian and Spanish Bonds

I mentioned Thursday morning that in the upcoming ECB press conference, the market was expecting (demanding?) that the ECB pull a Fed and start buying Italian and Spanish debt.

The ECB press conference today may be a form of catalyst as the marketplace is pressuring Trichet to reinstate sovereign debt purchases, which apparenly have not been utilized the past four months.  With both Italy and Spain the current focus, it would seem like Trichet would open the door to this which might appease markets.  The 'big bailout'f und (ESFS) is not yet funded, and not looking to be operational until end of year - so the market is looking for a bridge in the meantime
Rather than do this - which I believe led in large part to the mini crash Thursday - Trichet waited, with probably good intent to pressure the 2 countries (esp. Italy which has been out of the limelight unlike Spain) into quicker reforms.

Friday morning I mentioned there were really only a few options here.

Frankly I don't know of any solution to Europe aside from (a) it breaking apart and allowing the member countries to follow the U.S. and Japan solution - debase the currency or (b) the ECB turning into the Fed and taking trillions of assets on their balance sheet by turning into the U.S. or Japanese central bank or (c) some sort of crazy plan where American citizens begin taking on European debt as the Fed somehow does something crazy that supports the ECB.

Position b does not seem plausible YET in Europe but I feel will be the eventual situation. Position c would be Armageddon type of situation, simply because asking the Fed to support another country (or continent) to that extent would seem incredible. Position a would be messy but frankly Europe would not be in this mess if they each had their own currency to debase. (see Iceland!)
Then after European markets closed, the rumors about Trichet following through on what I said the market demanded Thursday, started floating out - leading to the stock market reversal.

We are in some form of (b) and (c) from best I can tell.
  • European Central Bank President Jean- Claude Trichet started buying Italian and Spanish assets today in his riskiest attempt yet to tame the sovereign debt crisis.   Italian and Spanish bonds surged as the ECB entered the market, sending 10-year yields down more than 70 basis points.
  • 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 and undermining its credibility. Germany’s Bundesbank opposes the move.
  • Because the ECB will have to spend considerably more to have an impact on the bond markets of the euro area’s third- and fourth-largest economies, it may not be able to continue to sterilize its purchases by absorbing the equivalent amount from banks via term deposits, said Carsten Brzeski, senior economist at ING Belgium in Brussels.  That would amount to swelling the money supply, or quantitative easing, which may in turn fuel inflation. “I don’t think that very large volumes -- like 50 billion a week -- can be sterilized,” Brzeski said. “Then they risk throwing their very last principle overboard.”
  • While the ECB may be playing for time until the EFSF is ready to take over bond purchases, between them they may be forced to hold “close to half of the traded Italian and Spanish debt, or around 850 billion euros,” Cailloux said.

I'm no expert on the ECB but from what I've been reading they do not have unlimited ability to 'print' ala the Fed, due to Germany's Weimar experience. However, to buy this Spanish and Italian debt - the money has to be coming from somewhere. It is unclear where (if anyone is an ECB expert feel free to chime in!), and I am wondering if the ECB is utilizing their unlimited swap line with the U.S. Federal Reserve. So in theory the Fed is printing money, letting the ECB borrow it, which allows the ECB to buy the sovereign debt, and send the Fed an IOU. I could be wrong but I think with gold up over 3% to >$1700, this is how it is working even if the banks are not saying it out loud. If this is how it is working, best to keep it quiet until someday down the road because the uproar in Washington would be supreme.

(below chart does not have today's move within it)

Generally the ECB would not want to do this sort of strategy, being more conservative than the Fed but (a) this is a crisis and (b) they can rationalize it as a short term bridge until the ESFS is funded and ready near the end of the year. 

Again, I could be wrong - but if I am, I do not know where all this money is coming out of the sky to fund the Italian and Spanish purchases. 

I believe this is the far more important story today, and this 'bailout' is more important than the U.S. downgrade, although the latter has more shock appeal to the masses.  That said, I'm still unclear on the long term solution because the ESFS needs to be funded by member states such as France who I have been pointing out for a year has a pretty junky debt to GDP ratio itself, and how big is big enough for the ESFS to support Italy and Spain?  I am not sure there is anything 'big enough' to bail out the situation other than the ECB finally relenting and printing (either by being given authority to do so, or using the Fed somehow).

On top of all this, the Fed meets this week and it will be interesting to see if they have anything new to say in tomorrow afternoon's statement.

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