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Dawn Kendall: Draghi and ECB’s delicate balancing act

Dawn Kendall MM blog

European Central Bank president Mario Draghi’s press conference earlier this month was eagerly anticipated by the markets. Great expectations had been pinned on his words in light of hints he had made over the previous fortnight that the ECB would act boldly to quell market jitters regarding peripheral debt, Spain and Italy.

Bond markets had rallied substantially in anticipation of his comments, with Spanish sovereign bond yields reducing to 6.60 per cent, so it is unsurprising that when the pronouncements finally came, they were not enough of a boost.

The salient points were:

• The ECB would be willing to buy sovereign bonds directly in the secondary market but this would not be a reopening of the special markets programme. This action is not necessarily linked to sterilisation – such as a reduction of liquidity at the short end of the curve – which has been a characteristic of the Securities Markets Programme. Neither is it an immediate move; it is still in the modelling and planning stage.

• Any buying programme can only be triggered by an official governmental request to the European Financial Stability Facility and European Stability Mechanism, including a signature against a memorandum of understanding.

• It appears the ECB would not insist on seniority status of the purchases.

• With regard to the macro outlook, Draghi acknowledged the risks to the downside on growth and this view was largely unchanged.

• Inflationary risk remains benign in the eurozone and Draghi expects it to dip below 2 per cent in 2013.

What he didn’t say:

• That the EFSF or ESM would be given a banking licence.

• That there was total agreement between the whole membership of the governing council of the ECB.

In fairness, this statement was as good as it could have been under the circumstances.

Draghi is treading a fine line between taking a principled position as the president of the ECB and allowing enough for the markets to ease yields downward.

It is debatable how united the ECB is on this action and that is why Draghi was cautious in his wording. German Council member, Jorg Asmussen, did not attend the meeting.

Both the Bundesbank and German government are split on how the market crisis should be approached, so it was significant that chancellor Merkel and finance minister, Wolfgang Schäuble, were supportive of the ECB.

The statement was carefully worded to say that nation states have to apply for formal assistance. This is a tricky point. Until now, both Italy and Spain have taken pride that they would not request sovereign aid. The tone from the two prime ministers has now softened and both expressed their satisfaction with the plan.

Peripheral sovereign bond yields have widened once more, with Spanish paper now trading back in the 7 per cent danger zone. Further machinations are expected during the summer months and we should be mindful of further weakness in the currency.

Key to further progress is the German Federal Constitutional Court decision on lawsuits, which might challenge the country’s participation in the permanent eurozone rescue fund, the ESM, and the fiscal pact on 12 September. Earlier this month, the court held a public hearing to examine complaints that participation in the fund and the fiscal pact violated German law by removing some of parliament’s authority over the national budget.

Of course, markets are impatient and the measured tones of the statement were not well received. Traders like to see bold, positive action but on this occasion the ECB was unable to deliver in this style.

Over time, if it can achieve consensus and devise appropriate models, the markets will start to be kinder.

The ECB cannot be seen to offer a free lunch to weaker states and must listen to the concerns of the largest and strongest economy – Germany. Being a confederation of 23 states, all with their internal dynamics and political posturing, Draghi’s action can be viewed, if anything, as a master performance of diplomacy.

Dawn Kendall is senior investment manager at Architas

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