Asia Economy

Markets Setting Themselves Up for Another ECB Letdown?


Global markets rallied on confirmation that the European Central Bank (ECB) had signed off on a highly anticipated, unlimited bond-buying program, however, experts remain skeptical on how long the euphoria will last given continued challenges facing the single-currency bloc.

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The program - called Outright Monetary Transactions (OMT), aimed at lowering borrowing costs for governments struggling with unsustainable debt levels - involves the purchases of sovereign bonds in the secondary market with maturities of up to three years for countries implementing approved fiscal austerity measures.

It's the third bond buying program the central bank has announced in recent years. This gave a boost to equity markets worldwide with the S&P 500rising to its highest level in more than four years on Thursday, while set for their biggest daily gain in nearly five weeks on Friday.

But according to Jim Nelson, Portfolio Manager at Euro Pacific Capital, the recent upside in risk assets is a case of “unjustified optimistic frenzy.”

In a note titled “European Central Bank's Bond Buying Changes Nothing,” Nelson says without significant support from surplus nations like Germany and the Netherlands, the central bank will accomplish little more than “spinning its wheels,” adding that there is no certainty such support is forthcoming.

Germany has demonstrated a lot of resistance to expanding the euro zone’s bailout fund. In fact, Bundesbank President Jens Weidmann was the only member of the ECB’s 23-member Governing Council to vote against the bond-buying proposal.

Weidmann on Thursday said the program is “tantamount to financing governments by printing banknotes,” adding that it may encourage countries to postpone necessary reforms.

But Nelson says the fact that the bond buying is linked to aid programs is decidedly negative for equities.

“If there are austerity conditions attached to aid, the nations receiving the assistance will almost certainly remain in, or slip back into, recession. This has been the base case for the European economy all along, and it appears nothing has changed,” Nelson wrote.

Greg Gibbs, FX Trading Strategist at Royal Bank of Scotland, is wary about whether politicians will in fact be able to garner enough public support for the necessary austerity measures.

“Something similar to the political crisis in Greece this year could unfold; arguably the trigger point this year for the latest round of Euro crisis actions,” Gibbs wrote in a note.

Greece continues to face social unrest over unpopular austerity measures and spending cuts that were put in place to secure bailout funds from the euro zone.

Vasu Menon, Vice President, Wealth Management, Singapore at OCBC Bank, says while he believes the ECB has taken a step in the right direction, there are many hurdles ahead.

“The question here is whether European politicians will be able to reign in their budget deficits sufficiently to satisfy the markets – the structural issues have to be satisfied,” he added.

One of the biggest risk events ahead will be the German constitutional ruling on the legality of the European Stability Mechanism (ESM) bailout fund on September 12, he said.

“The ECB and Draghi can only execute what is said provided he has the agreement of the Germans. The Germans are putting up opposition, clearly the Bundesbank is not happy with the move.. there are still a lot of uncertainties out there,” Menon said.

Judging by the extent of the market rally following the two long-term refinancing operations(LTROs) last December and again in February, Menon says positive momentum in risk assets may last just 4-6 weeks.

Via the LTRO programs, the ECB lent money to banks at very low rates so that they could use that to buy higher yielding assets.

“We had two LTROs, which added up to 1 trillion euros, even with (that) we saw the markets rally like they are right now, we saw bond yields coming down, but it didn’t last because at the end of the day the markets went back to fundamentals,” Menon added.

- By CNBC's Ansuya Harjani