ECB Strategy Working Now, but Will It Work Long-Term?

Following a dramatic end to the trading week that saw Italy pledge to speed up its austerity measuresand S&P downgrade America's credit rating, the European Central Bank decided this weekend it had to act.

European Central Bank
European Central Bank

Bond yields in both Italy and Spain fell sharply at the market open Monday, while stocks in both countries rose sharply on news of the intervention from the ECB.

Having welcomed promises from Spain and Italy to speed up reform, the ECB said “it will actively implement its Securities Markets Programme. This programme has been designed to help restoring a better transmission of our monetary policy decisions—taking account of dysfunctional market segments—and therefore to ensure price stability in the euro area.”

That's widely regarded to mean the central bank will step into the market Monday morning to buy Italian and possibly Spanish debt in a bid to lower borrowing costs for both euro zone members and boost confidence in Europe’s banking sector, which has been hit hard by the sovereign debt crisis.

Economists at Barclays Capital welcomed the move, which they believe should “provide some relief to investor sentiment,” but warned that lots of questions about the size and scope of the plan remain.

“Since these markets, particularly that of Italy, are much greater in size than the markets in which the ECB has so far intervened (Greece, Ireland and Portugal), it could be difficult for the euro system to engage in purchases of significant enough size in order to arrest the upwards shift in spreads and yields” said Barclays Capital European economist Julian Callow in a research note.

Others are more confident that the ECB can significantly lower yields on Italian and Spanish debt.

“The ECB bond buying will stop the collapse of the bond market in countries under stress, which was unfolding in a self-fulfilling manner, and buys a significant amount of time,” said Jacques Cailloux, the chief Europe economist at RBS in London in a note to clients.

“The ECB intervention will in our view bring an immediate tightening in Spanish and Italian bond spreads of the order of 100 to 150 basis points. In the absence of liquidity, investors will sell Germany and German bond futures initially, although recession risks should cap the selloff in the region of 2.75 percent in the 10 year.”

While the ECB move could have a serious impact in the short-term, Cailloux warns over the longer term the move will mean more fiscal austerity and weaker growth.

“Any signal that the ECB is only intervening on an interim period – that is, until the European Financial Stability Fund is up and running - will give the market a sentiment that there is a finite limit on purchases In this context (and) uncertainties about the ECB's ability to defend spread levels at any cost will be challenged” said Cailloux.

Writing in the Daily Telegraph on Monday, UK Chancellor George Osborne called for greater financial integration in the euro zone as the only viable long-term solution to the crisis.

Osborne urged euro zone countries to develop a euro bond which would see the debts of weaker euro zone members combined with stronger countries like Germany and promised new reforms in the UK this autumn to kick start growth, hinting at tax cuts and cutting out governmental red tape.