ECB on course to act strongly or disappoint mightily

FRANKFURT Mon Jul 30, 2012 1:08pm EDT

A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012. REUTERS/Alex Domanski

A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012.

Credit: Reuters/Alex Domanski

FRANKFURT (Reuters) - European Central Bank President Mario Draghi must back up his pledge to do what it takes to protect the euro when the bank's policymakers meet on Thursday or else face deep disappointment from investors hungry for - and expecting - immediate action.

In his boldest comments to date, Draghi said last week that, within its mandate, the ECB was ready to do whatever it takes to preserve the euro, fuelling expectation the bank could revive its bond purchase program as it did a year ago when it started buying the government debt of Spain and Italy.

The talk has already lowered Italian and Spanish bond yields, and the extent to which markets are now primed for a move on Thursday was clearly spelt out in a Reuters poll.

Nineteen out of 24 money market traders said they expect the ECB to restart its mothballed bond-buying program with purchases of Spanish and Italian debt, with 10 out of 19 expecting it announce this on Thursday.

But such a step is far from certain, and the ECB may hold off to intervene in tandem with the euro zone's EFSF rescue fund.

Instead, the ECB could explore new policy tools such as outright asset purchases, or quantitative easing, which Britain, the United States and Japan are using to stimulate growth. There have also been recent suggestions that it could empower national central banks to broaden their asset buying abilities.

The ECB is under intense pressure from within and outside the euro zone to intervene and bring those governments' soaring borrowing costs under control as the debt crisis deepens and increasingly poses a risk to the global economy.

Reflecting the increased tension, U.S. Treasury Secretary Timothy Geithner flew on Monday to Germany, the euro zone's biggest economy and key to any euro rescue plan, and met Germany's finance minister Wolfgang Schaeuble.

After their meeting, on a remote North Sea island where Schaeuble interrupted a holiday, they issued a statement saying they were optimistic about reform efforts in the euro zone. Geithner later met Draghi in Frankfurt, but he left that meeting without comment, and no statement was issued.

The ECB chief will also meet Bundesbank President Jens Weidmann, a strong opponent of the ECB's government bond purchase program, ahead of Thursday's ECB meeting, a central bank source said.

The prospect of a stronger ECB crisis response drove Italy's 10-year funding costs below 6 percent for the first time since April at an auction on Monday, but fresh turmoil is likely if Draghi fails to convince investors on Thursday.

"With expectations running high, the scope for disappointment at Thursday's ECB policy meeting has increased considerably," said Nicholas Spiro at Spiro Sovereign Strategy.

SUMMER

The August meeting usually draws little attention and in fact the ECB used to skip the summer month's meeting until 2006 - the last year in which it took policy action in August.

The ECB could well break with tradition this year.

Huw Pill, economist at Goldman Sachs and a former senior ECB official, said the ECB could decide on Thursday to buy unsecured debt of bank or firms via the national central banks to address countries' individual weaknesses and to keep risks contained.

"We forecast the announcement of measures to permit national central banks to purchase private-sector assets under their own risk to implement ‘credit easing', within a general framework approved by the Governing Council," Pill said.

"Such targeted measures offer a way of managing the consequences of (financial markets') segmentation for the private sector and real economy while maintaining the pressure for governments to act on fundamentals in a manner that reduces and ultimately eliminates the segmentation over time," he added.

The ECB has resisted so far stepping up its action for fear of taking away incentives for governments to implement tough reforms. Jean-Claude Juncker, head of the Eurogroup of euro zone finance ministers, said on Sunday euro zone leaders would work with the ECB to stabilize the euro.

The euro zone rescue fund could, for example, buy government bonds on the primary market, flanked by ECB purchases on the secondary market, media reports said last week. That way, any intervention would only come under certain conditions.

The ECB would like Europe's permanent ESM bailout fund to take over the bond purchases completely, but its limited size could make its intervention less effective.

One idea, favored by France, is to give the ESM access to ECB funding with a banking license. Austrian policymaker Ewald Nowotny said last week such a step had merits - breaking ranks with colleagues.

The Reuters poll showed 17 out of 24 money market traders expect the ESM to get a banking license.

Another cut in interest rates seems less likely as the ECB assesses the impact of its July rate cut to a new record low at 0.75 percent. At that meeting, the bank also decided to stop paying banks interest on their overnight deposits with it.

An earlier Reuters poll showed 44 out of 69 economists expect the ECB to cut rates again by year-end, with seven saying the bank would cut in August.

BIG BAZOOKA

Draghi's remarks last Thursday left many in the market wondering whether his message had been intended and if so how far the ECB would be prepared to go.

"If you had just landed from planet Mars, and this was the first time that you had heard the ECB speak on this issue, you might think that it was about to fire a big bazooka at sovereign bond markets," said David Mackie, economist at J.P. Morgan.

"But, having listened carefully to the central bank over the last two and a half years, we don't think that is about to happen," he added.

Draghi's candid remarks took some of his fellow Governing Council members by surprise, having not agreed with them before hand on the message he would send. This has prompted concerns Draghi may have raised false hopes in the market.

"Nothing new has been discussed (on action ECB could take), but Draghi is not a man to make comments lightly and at the end of the day he is the one calling the shots," said a euro zone central bank source. "There was always going to be a time when Draghi decided he had to act."

Another source said Draghi was not flagging an imminent move, and any action would likely come only in September or October, in conjunction with euro zone governments, and with a request from Spain for a bailout program, which Madrid was still trying to avoid.

(Additional reporting by Marc Jones and Rahul Karunakar; Editing by Jeremy Gaunt)

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