ECB May Come Out Swinging, but Will It Be Enough for Markets?

The European Central Bank is expected to come out swinging Thursday with a bond buying program intended to knock down rates for its weaker sovereigns, but the plan may not pacify markets for long if Spain doesn’t soon commit to use it.

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ECB President Mario Draghi pledged this summer to do whatever it takes to keep the euro intact, including purchases of shorter duration Italian and Spanish bonds. News reports quoted sources saying the ECB would announce a plan to purchase bonds with maturities of less than three years. A Bloomberg report said the plan has no size limits and would not include a measure to establish caps on yields, as desired by Spain.

The program would also contain a conditionality forcing countries that would benefit from it to first request assistance and agree to comply with budgeting rigor. Spain has said it would not request needed assistance until it saw the details of the conditions and what was being offered, and it is yet unclear whether it would accept this plan, as reported.

“It’s still a constrained step because they’re only willing to make purchases as long as the country in question is willing to make its commitment to austerity measures,” said Paul Christopher, chief international investment strategist with Wells Fargo Advisors.

“It’s an important step, and it does quite a bit to really help underpin expectations that markets had built up over the last five weeks. You could see, for instance, that the euro picked up a half a cent on the news. What we really were afraid of is disappointment,” said Christopher. Spanish bond yields also declined after the Bloomberg report.

“To hear them say it’s going to be unlimited is really going to help in the short-term to brace markets against whatever Spain does,” he said.

Spanish Prime Minister Mariano Rajoy is also scheduled to meet with German Chancellor Angela Merkel in Madrid Thursday. Spanish newspaper El Pais reported in its internet edition Thursday that Spain would be willing to request a full sovereign bailout if no extra conditions are required of it since it is facing difficulty financing itself with elevated borrowing costs. The newspaper quoted government officials and said Rajoy will try to convince Merkel that Spain would seek the bailout if there are no tougher conditions such as pension reductions.

Rajoy, meanwhile, gave an interview to German newspaper, in which he called for a rapid solution to the euro crisis and the risk premiums that are driving up his country’s borrowing costs. He said risk premiums do not come from Spanish fundamentals but from doubts surrounding the euro.

“I think there clearly is going to be some gamesmanship going on,” said Boris Schlossberg, managing director of foreign exchange strategy at BK Asset Management. Schlossberg said Spain may want Italy to join it, in requesting help from the ECB.

Any bond purchases by the ECB are expected to be “sterilized,” which means the ECB would remove from the same amount of money that it spends from the system. That could help alleviate German concerns that the central bank would be “printing money.” In contrast, the Fed has added to its balance sheet when it made bond purchases as part of quantitative easing programs.

Schlossberg said it is also difficult for the ECB to give too much detail, ahead of an important ruling by a German court next Wednesday. The German Constitutional Court is considering the legality of the ESM, the EU’s new bailout fund.

George Magnus, senior economic advisor at UBS, said he expects Spain to quickly ask for aid, but he thinks the news reports and some market expectations are perhaps too aggressive on the ECB program. “People think there may be fixed caps on interest rates, or unlimited intervention,” he said. “I don’t think Draghi will announce either of those. He will sound generous, saying we will intervene on an adequate scale. I don’t think he will commit to anything very specific, to be honest. It will help when they actively use the program.”

The yield cap, if enacted, would have guaranteed some rate relative to bunds. “It’s pretty difficult to put down a yield cap, and if they put that down there’s difficulty in defining it and there are concerns, like could they maintain it? Would it be a credible line in the sand,” said Brian Kim, RBS currency strategist.

He said one idea may be that the ECB could start using the program with purchases of Portuguese or Irish debt. That would “show that if you’re part of the program and you show some reforms, you could get some of these benefits,” he said. Kim said he does not expect to see the cap on rates.

Christopher said another key to the new ECB plan is whether the so-called troika – the ECB, European Commission and IMF – agree to be flexible with Greece’s bailout plan. Greece is seeking an adjustment that would delay some austerity measures, and the troika will review its progress. Many German politicians oppose the extension and Greek officials are scrambling to find budget cuts.

“If the troika comes back with something positive, we’ll say okay, that really helps put Greece in the background again,” Christopher said. “If the ECB gives with one hand, and the troika takes back with the other, the ECB is really on the hook.”

The ECB statement is expected at 7:45 am ET, and is to be followed by a press briefing by Draghi at 8:30 a.m. where details of the program are expected to be revealed. Some analysts say it’s possible the ECB could also announce a reduction in its refi rate of 0.25 percent. Spain also issues up to 3.5 billion euros in two-, three- and four-year bonds Thursday, ahead of the ECB statement. The Bank of England also meets Thursday.

Schlossberg said the euro has held in the 1.25 area while traders watch to see what both the ECB and Fed will do. “If Draghi doesn’t make a forceful argument for what he’s going to do, there will probably be some volatility and the euro will decline. On the other hand, there’s a lot of U.S. data,” he said. Weak numbers could encourage the Fed to act, he said.

There is a fairly busy calendar of U.S. economic data Thursday, starting with the ADP private payroll report at 8:15 a.m. ET, then weekly jobless claims at 8:30 a.m. ISM nonmanufacturing is expected at 10 a.m. That report follows a disappointing report ISM manufacturing sectoring, released Tuesday. That report showed manufacturing contracting at its fast rate in more than three years. The index fell to 49.6 in August, just under 49.8 in July. Economists had expected a reading of 50, and anything below that shows contraction in the sector.

Aside from Friday’s jobs report, it is one of the biggest days for economic data before the Fed meets next week. Some economists believe there’s a chance the Fed could announce some further easing next Thursday, but many believe the odds are for an announcement at a later date. However, Schlossberg said the market may believe if the data is very weak and the jobs report falls short of the 120,000 nonfarm payrolls expected, the Fed could be forced into action.

A weak batch of U.S. data would also be supportive for the euro, he said.

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