Is ECB intervention in the Italian and Spanish bond markets working?
Since Monday the ECB has been buying Spanish and Italian debt in the secondary market aiming to drive down the yields and hence ensure that both countries can afford to borrow from the debt markets.
The yields on both countries’ debt had increased sharply in the preceding fortnight (post-the latest Eurozone crisis summit) in a pattern which has become strangely familiar over the past year – the yield hits 6%, the country denies there is a problem, it hits 6.5%, more denials and suddenly it is at 7% and a ‘bailout’ is being arranged.
Whilst Ireland, Portugal and Greece represent 4.5% of EU GDP between them, Spain is 8.7% alone and Italy is 12.7%. They are too big to fail – but also possibly too big to bailout.
If Italy and/or Spain were to require a bailout they would obviously not be able to participate in the EFSF – at which point the increased costs to France (in particular) would become perhaps insurmountable. In other words if one of these two go, the whole crisis coping mechanism goes with it. (Not to mention the fall out in the banking sector).
So – back to the original question, is the ECB intervention working?
But in the CDS market (credit default insurance) a different picture emerges – one of continuing and rising concern for Spain and Italy.
If the markets were genuinely reassured we would expect CDS rates and bond yields to fall together. As CDS rates (where, crucially the ECB is not intervening) are continuing to rise this looks like entirely artificial price moves in the bond market caused by the ECB acting as buyer of last resort.
The question becomes – what happens when the ECB stops buying? The answer may be a swift return in bond yields to uncomfortably high levels.
So – why can’t the ECB just continue buying? Well it could. But it would soon own a substantial proportion of outstanding Italian and Spanish government debt – something which Northern European tax payers are unlikely to be happy about and a situation which may be sustainable. What will it do to confidence if an international central bank (with no power of taxation) is standing behind a substantial segment of the debt of two major economies?
Once more it looks like the Eurozone’s ‘solution’ is just an attempt to buy time – let’s hope they use this time well.