ECB Needs to Signal Intervention: Analysts
July's rate hike could well have been Jean-Claude Trichet's last as president of the European Central Bank, but markets will be watching for signals that the bank is preparing to take some role in future interventions in European markets, economists and analysts told CNBC.com.
Trichet signaled in his press conference in July that the bank would not be raising its core interest rate in August. Nevertheless, as fears over contagion of the euro zone sovereign debt issues grow and Italy and Spain become sucked into the crisis, the ECB is being looked to for a potential bridging mechanism while longer-term solutions are worked through.
Reactivating the ECB's bond buying program is a necessity if pressure on Italy and Spain is to be alleviated, analysts said.
Italian 10-year spreads have widened to more than 6 percent in recent days as domestic politics and contagion weigh on the country's outlook. Italy, the third-largest economy in the euro zone, is burdened with a debt mountain totaling 120 percent of its gross domestic product (GDP).
The July 21 meeting of European Union heads of government saw, among other measures, the European Financial Stability Facility (EFSF) given more flexibility to intervene in struggling countries and – crucially for Spain – to participate in the recapitalization of their banking systems.
These reforms still need to go through the political grinder in Brussels and in national capitals, and the ECB could be needed to act to provide stabilization funds in the interim.
An address by Italian Prime Minister Silvio Berlusconi to parliament after markets closed on Wednesday night failed to calm market sentiment. Berlusconi promised a growth plan, which included labor market reform. However, continuing concerns over the stability of his cabinet, particularly the role of finance minister Giulio Tremonti, who was in Luxembourg to meet euro group head Jean-Claude Juncker, continue to weigh on sentiment.
A British think thank the Center for Economics and Business Research, said that even in better-case scenarios, Italy is still likely to default unless it experiences a dramatic increase in growth. With bond yields at current levels and growth slow, the chances of the country reducing its debt stock below 128 percent of GDP and avoiding a default are low, the CEBR report said.
In this context, some form of intervention by the ECB will be needed to calm markets before longer term solutions can be found.
"It is to some extent anticipated in markets that the ECB could be some kind of bridge until the EFSF is fully implemented. As we know, the EFSF is not ready before the end of this year to buy up in the secondary market, but it would be a massive positive event in markets if the ECB stepped in and put away its reluctance to act in the market," Danske Market chief analyst John Hydeskov told CNBC on Thursday morning.
"They should step in," he added.
Jens Larsen, chief European economist at RBC Capital markets, agreed.
"I think the key concern here is that despite all these reforms that enable the EFSF to do things, that it won't have the financial capacity to do them and to reassure investors. That's where I think the ECB comes in. It's a question of being there now, before the EFSF is in place, but it's also the fact that the central bank has a different size of balance sheet, a different nature of balance sheet and a different ability to intervene, so the ECB has to play a role," Larsen told CNBC.
“The problem is the timetable, the political and technical execution risk and the growing pressure we are seeing in sovereign and broader markets," Andrew Balls, head of Pimco's European portfolio management, told CNBC.com.
"The reason this is relevant to the ECB is firstly the macroeconomic implications and secondly the fact that in May last year with the creation of the EFSF, the ECB provided a bridging function then while the governments put the political and technical requirements into action for the EFSF to function," Balls added.
“I'll be looking on Thursday for any indication that we could have the same sequencing now, that if it's going to take a lot of time - which seems likely - for the fiscal policymakers to put in place the ability of the EFSF to be an external balance sheet and a circuit breaker that would be credible in the case of Italy," he also said.
Markets remain unconvinced by the likelihood of the second iteration of the EFSF – the EFSF 2.0 as some call it - providing a meaningful solution to the current sovereign debt crisis.
“Recent activities in Europe have seen a deal to successfully ring-fence a Greek default from the rest of the euro zone financial system agreed, but it offered no substantive debt relief to reduce the likelihood of a future default," Percival Stanion, Head of Asset Allocation at Barings, wrote in a note to clients on Tuesday.
"It furthermore gives few clues as to how a market run on Italy might be approached. However, by transforming the European Financial Stability Fund into a multi-purpose slush fund, the guardians of the euro zone appear to have done enough to cause investors to close down shorts and reduce underweights. While this half-baked deal may result in a temporary reduction in euro zone risk premia, its ability to put an end to the sovereign crisis remains unproven and unlikely," Stanion added.
At Deutsche Bank, however, economist Gilles Moec very strongly disagreed.
"Honestly I think the EFSF 2.0 is a very important step. It's a very good deal. Everyone is getting overly concerned and they want this thing to be iron clad," he told CNBC.com.
"It is totally unwise to think that we should increase the size of the EFSF to cover Italy in the same way that Greece, Portugal and Ireland have been covered…The fact that the EFSF was finally made more flexible – which is something that should have been done last year – makes it less important to increase the size," Moec added.
"Spain, for instance, doesn't need a three-year program. Spain needs money to recapitalize its banks. That would cost anywhere between 50 and say 80 billion euros. That's much less than the 300 billion euros it would cost to replicate for Spain the Greek cover. Since you could intervene in this more flexible way, this would leave quite a lot of firepower to intervene for Italy," he explained.
Heading Towards Fiscal Union
Ultimately, analysts said, the euro zone is going to have to start to coalesce into a more effective fiscal union, with the EFSF and the European Stability Mechanism, another crisis response facility, at the leading edge of that process.
“If they are going to use this to eventually support Italy and Spain, then again I would see that as a greater step towards greater fiscal union and Eurobond issuance, with the EFSF playing that role in the first instance," Balls said.
"The problem is all the technical and political execution risk and the question mark over the commitment of the core countries, particularly Germany, to go down that route. But we are getting to a world of corner solutions, not just incremental steps," he added.
"One is to move towards greater fiscal integration, greater cross-border support and quite likely euro bonds; the other extreme is ongoing instability and defaults in a number of countries, not just Greece. In that context, it will be interesting to see if there is any kind of signal on the ECB’s role from Trichet on Thursday, both on the macroeconomic case for quantitative easing and the crisis management role the ECB could play in providing a credible external balance sheet," Balls added.
As ever, the market will be looking at the nuances of Trichet's language in his press conference, but rather than waiting for "strong vigilance", they will be waiting for some kind of hint about interventions.
"I think that at this stage, especially if the market kind of stabilizes… Trichet would probably be reluctant to be too precise in his statement. We think that Trichet will hint at the possibility of intervention, without being too specific," Moec said.
"They hate to do that. When they intervened in May of last year they did so without any warning, without any statement. This is probably the best way to engineer intervention. Don't speak, don't warn, just do it and don't justify yourself," he added.