Jim Jubak
The euro can't be undone. High yields are unacceptable. And, yes, the European Central Bank will resume buying Spanish and Italian government bonds as soon as it can work out which bondholders would be repaid first in the event of a default.
That was the sum total of today's action from the European Central Bank. After tantalizing the financial markets with hints of another interest-rate cut or another round of bank lending, along with a proposal to give the European bailout fund a banking license so it could borrow directly from the central bank, ECB President Mario Draghi delivered only this very limited package.
European stock markets that had been up as Draghi's news conference began slowly moved into negative territory. An hour after Draghi's remarks, the German DAX index ($DE:DAX) was down 0.66%. Futures on U.S. stocks moved into the red before the open, and the S&P 500 Index ($INX) ended down more than 10 points for the day.
In the short term, financial markets were left disappointed, after having been led to expect something dramatic. But that's the short term.
In the long term, I think the bank's failure to act leads to serious negative consequences. Here's why.
Still waiting
The simplest way to characterize the action, or perhaps the inaction, of the ECB is that the bank has moved to defend the Italian and Spanish bond markets and left the rest of the eurozone to hang in the wind -- or to continue waiting for politicians to come up with a solution, if you prefer that formulation.
By saying that the bank will resume buying Italian and Spanish government bonds -- over the strenuous objections of Germany's Bundesbank, Draghi not too subtly hinted -- the ECB has signaled to bond traders that they don't have the field to themselves.
The traders will have to think about the risk that the bank will buy -- driving prices back up and yields back down -- before they short these bond markets. The bank didn't draw a line in the sand, as some economists had suggested, so the markets don't know when the central bank will decide to step in. But I think it's a good bet that Draghi wants to drive yields on Spanish 10-year debt significantly below the 7% mark that the Spanish government has repeatedly called unsustainable.
Bond markets haven't been especially impressed. In the hour after Draghi spoke, the yield on Spanish 10-year debt moved up to 6.78% from 6.68%, and the yield on the Italian 10-year bond increased to 6.1% from 5.81%. U.S. Treasurys rallied as those markets opened, with the yield on the 10-year Treasury falling as buyers stepped up in their search for safety.
The bond market's reaction is completely understandable. Draghi gave no indication that the central bank was about to undertake a big intervention. Past moves have been too small to change the trend in the bond market for long, and with Draghi noting Bundesbank opposition to a resumption of bond buying, it's only reasonable to assume that this effort, too, will be too small to matter.
Not believable
Details might have helped the central bank's credibility. Saying that the bond-buying program will start once the bank has decided whether the European Central Bank can jump to the front of the line of creditors if Spain or Italy defaults is like saying that the eurozone will have unified deposit insurance when it can persuade Germany to back deposits for savers in Spain and Italy. Neither is likely to happen.
And there's also a technical question of where the bank will intervene on the yield curve. Spain has been selling short-term debt by the cartload recently, because long-term rates are punitively high. That has gradually driven up short-term yields, the amount Spain has to pay the bond-buyers.
So will the central bank buy long-term or short-term bonds when it decides to intervene? That's important to traders trying to decide which bonds to sell short, betting they'll fall in value, and which short bets to shy away from. And it illustrates exactly how big the task ahead of the ECB right now.
