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ECB Rally Sputters as Leaders Fail to Act on Spain, Greece

The European Central Bank's bond buying plan has helped spark a rally in risk assets and eased funding costs for the region's most troubled economies.

European Central Bank
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European Central Bank

But rather than taking advantage of the breathing space, European finance ministers meeting in Cyprus over the weekend suggested they were in no rush to resolve key outstanding issues.

The uncertainty is already affecting the markets, with European stocks falling on Monday from the 14-month highs reached on Friday and the euro also weaker against the dollar.

Policymakers have decided to defer urgent action on three issues: a sovereign bailout for Spain, a decision on Greece after the country requested a two-year extension on bailout terms, and a common supervisor for Europe's banks.

On the first, the Dutch finance minister told CNBC, it was up to Spain to request aid. But Spain's El Pais newspaper reported over the weekend that the country's Prime Minister Mariano Rajoy was reluctant to ask for help, while the country's finance minister wanted to ask for assistance as soon as possible.

The uncertainty has led to plenty of speculation and rumors. On Friday, a Dutch newspaper reported that Spain was in talks with the ECB and the International Monetary Fund over a 300 billion euro ($386 billion) bailout. But both the ECB and the IMF were quick to deny any talks.

"Madrid now feels emboldened to go it alone and seize the window of opportunity in financial markets to get as much of its debt out the door as possible at what, for Spain, are still relatively favorable yields," Nicholas Spiro, managing director of Spiro Sovereign Strategy, wrote over the weekend. (Read More:Trichet: Worst Crisis Since Second World War.)

But Spain's financing costs are already rising again. Yields on two-year bonds are up 60 basis points since the ECB announced its latest program, according to Spiro. Meanwhile 10-year yields rose 13 basis points on Monday to 5.96 percent.

Antonio Garcia Pascual, an economist at Barclays Capital, said the government was hoping that the results of banking stress tests and structural reforms, which will likely accompany the budget announcement, would help further reduce Spanish bond yields.

But, he said, if bond yields didn't fall after that, it would be a signal to the government that the market wants more, leading Spain to finally choose a full bailout.

On the second issue of Greece, it’s becoming clear that the country's foreign lenders are partial to the idea of granting an extension. But Austria's finance minister threw cold water on the idea over the weekend, saying the country will get only a "few weeks" more to meet targets.

"Now we have this weird equilibrium where we don’t know whether Spain is going to apply for this aid which has been promised and also the Greek process is going to go into a little bit more (of a) grey phase. I think the European news is going to be less clear-cut positive from here and that could be one of the catalysts for a pullback in risk assets," Jens Nordvig, global head of foreign exchange strategy at Nomura, told CNBC.

Meanwhile, a major disagreement has broken out over the third issue on banking union. The European Commission has put forward proposals to bring the thousands of banks in the euro zone under the supervision of the ECB.

But Germany's finance minister Wolfgang Schaeuble pushed back on the plan over the weekend. A single banking supervisor is needed before Europe's rescue funds, the European Stability Mechanism and the European Financial Stability Facility, can provide direct aid to banks in Spain.

But Jacek Rostowski, Polan's finance minister, told CNBC in Cyprus, the ECB bond-buying plan has bought some time and policy makers should not rush attempts to agree on a banking union before the end of the year.

"Now all of us would like to get this going as fast as possible. But ... it’s important to remember that the circumstances have changed,” Rostowski said. “And therefore it seems to me that banking union which is definitely necessary … both necessary and desirable itself, nevertheless does not have to be done in such a hurry as to make it … well, flawed."

—By CNBC.com’s Deepanshu Bagchee; Follow Him on Twitter @DeepBagchee

Contact Europe: Economy

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