Market rout as ECB dashes bond hopes
The European Central Bank has dashed hopes for a blitz of bond purchases to stem the debt crisis in southern Europe, setting off a sharp fall on European stock markets and a flight from risk across the world.
Mario Draghi, the ECB’s president, said the bank had not agreed to any sort of “Grand Bargain” with EU leaders to act as lender of last resort for sovereign states, insisting that it does not have a legal mandate to rescue sovereign states in trouble.
“We have a treaty and Article 123 prohibits financing of governments. It embodies the best tradition of the Bundesbank. We shouldn’t try to circumvent the spirit of the treaty,” he added, warning against the use of “legal tricks” to bend the bank’s mandate.
The comments caused consternation on trading floors, where expectations for a “shock and awe” action by the ECB have been running ahead of reality. Mr Draghi had earlier hinted that the ECB might be willing to do more if politicians deliver on a “fiscal compact” to anchor budgetary discipline at today’s summit in Brussels.
“This is big, he’s basically pulled the rug out from under the market,” said Brian Dolan at forex.com. “There’s a sense of shock right now because he previously suggested that if EU leaders got things together, the ECB would step up bond purchases.”
Italy’s 10-year bond yields spiked 47 basis points 6.43pc and Spain’s yields jumped 39 to 5.75pc, bringing the rally in Club Med debt to juddering halt. French spreads over German Bunds jumped 23 points to 122.
British Gilt yields fell below 2.12pc for the first time in modern history on safe-haven flows. The FTSE 100 fell 1.1pc.
Milan’s FTSE MIB index of stocks fell 4.3pc as banking stocks buckled despite the ECB’s support measures, with Intesa SanPaulo down 9pc and Unicredit down 7pc. The Paris CAC fell 2.5pc and the Dow fell 1pc in early trading on Wall Street. The euro tumbled over one cent to $1.33 against the dollar.
Almost lost in the drama, the ECB cut interest rates by a quarter of a percentage point to 1pc and offered sweeping measures to shore up the eurozone’s €23?trillion (£19.6?trillion) banking system and avert a dangerous credit crunch.
It extended its unlimited credit to banks (LTRO’s) from one year to three years, and halved the reserve ratio to 1pc to free up more than €200bn in extra liquidity. It will relax collateral rules to allow wider use of asset-backed securities, a life-saver for distressed banks that were running out of eligible “kit” for the lending window.
Mr Draghi said banks were facing “serious funding pressures”, compounded by the rush to raise core Tier 1 capital ratios to 9pc. The measures to shore up lenders are intended to avoid acute “deleveraging” as banks shrink their loan books and prepare to roll over €230bn in bonds in the first quarter of next year.
“The banking system has been taken care of to prevent another Lehman while they sort everything else out, but it doesn’t solve the eurozone’s liquidity trap,” said Jacques Cailloux, chief Europe economist at RBS.
“We remain fundamentally negative. It is a very severe crisis and in the end the ECB will probably be forced to step up bond purchases,” he said. “Essentially, it is already doing quantitative easing – whatever they say – if you look at their ballooning balance sheet (which stands at €2.4? trillion, or 26pc of eurzone GDP).”
Tim Congdon from International Monetary Research said the ECB bank’s support is highly significant and could prove a transforming moment in this crisis. The steps help to shore up the whole interlocking edifice of bank debt and sovereign debt, giving back-door support for governments.
“ECB lending to commercial banks can act as an important safety valve for the single currency project. It could gain valuable breathing space,” he said.
“The ECB is bending over backwards to help banks, reversing the crazy withdrawal of special credit facilities early last year. The banks can now borrow for three years at 1pc or so, and use the money to buy bonds at yields at 5pc, with gearing. It encourages them to purchase the bonds because returns could be fabulous provided the euro holds together.
“Mario Draghi seems to be a leader of far greater insight and capacity than (ex-ECB chief) Jean-Claude Trichet,” he said.
Mr Draghi said he had been “surprised” by market expectations over recent days, clarifying that his call for a “fiscal compact” from EU leaders includes both a shake-up of national policies to boost competitiveness, and EU rules “enshrined in legislation that constrain budgets ex ante”. The wording clearly implies that EU summit plans for sanctions to punish fiscal sinners after they have broken the rules is not enough.
He flatly contradicted leaked claims by EU officials that the ECB may use the International Monetary Fund as a conduit for disguised sovereign rescues.
“Let us not forget that the ECB is not a member of the IMF. One cannot channel money in a way to circumvent the treaty provisions. If the IMF were to use this money to buy exclusively European bonds, we think is not compatible with the treaty,” he said.
Christine Lagarde, the head of the IMF, said Fund will participate in efforts to contain Europe’s debt crisis but there is still a “lot of work to be done”. The IMF’s Asian and Latin American board members are certain to impose tough conditions on any global rescue for Europe’s rich, while US lawmakers on Capitol Hill are in near revolt over the issue.
The ECB slashed its growth forecasts for 2012 by a full percentage point to 0.3pc, implying a deep recession for Italy, Spain and the struggling periphery.
Europe’s banking woes have escalated into a global danger over recent weeks. Mark Carney, the Bank of Canada’s governor and head of the Basle-based Financial Stability Board, warned recently in London that Europe’s lenders risk setting off a fire-sale of assets if they shrink their books rather raised fresh capital. This could tip Europe into deeper recession and lead to worldwide contagion.
“The severity of the downturn will depend in part on how European banks delever. If only asset sales were used, up to €2.5?trillion of disposals would be required in coming months,” he said.