ECB's Pyrrhic Victory

The ECB has succeed in driving down Spanish and Italian yields sharply today. Italy's generic 2 and 10-year yields are off around 80 bp. Spanish yields have declined even more dramatically, with the 2-year off 110 bp and the 10 year yields off almost 90 bp.

These are greater declines than many would have expected. Some observers are trying to extrapolate from the price action the size of the ECB's operation today. It seems to be repeating the same mistake as the initial estimates of the size of BOJ's recent intervention.

Market conditions are important. For example, US fx intervention tends to be more successful because it seems to finesse the market, knowing key chart points and having a sense of how the market is positioned. In contrast, Japanese officials have traditionally tried to overwhelm the market with size, but often not enjoying the same degree of success.

We will not know how much the ECB bought today until next week when it announces the size of its sterilization operation. If the ECB rally steps up its purchases, which it can do, if it wanted, it is this sterilization process that poses operational risk to the ECB. Even last week, Trichet was adamant. The ECB does not engage in QE, which means the monetary impact of its sovereign bond purchases must be sterilized.

The ECB offers 7-day deposits to mop up the liquidity. In the past the ECB has found it sometimes difficult to fully sterilize bond purchases. AS the size of its bond holdings increase, this will likely become even more difficult. There has been some talk that the ECB could offer longer deposits, say 30-day tenors. In addition to this operational issue, there are a couple of other challenges the ECB faces.

First, it bond purchases are seen as a gap-filling gesture until the next flexibility of the EFSF is affirmed by national parliaments. However, the ECB can in theory buy much more than the EFSF given its size and the reluctance of some countries, including Germany, to increase the size of the EFSF. The argument that Barroso made that the size of the EFSF could be increased if necessary illustrates the rearguard/reactionary thrust still.

Second, if part of the problem in Europe is some kind of liquidity trap, doesn't ECB bond purchases aggravate it? These bonds are taken out of private sector hands and into the ECB's coffers, where they are intended to be held until maturity. It gives the private sector no incentive to stay involved and further reduces the liquidity of the peripheral bond market.

Third, the ECB has become the single largest owner of Greek, Portuguese and Irish bonds. It is estimated that the ECB owns roughly 20% of their outstanding bonds. If it were to do the same for Italy and Spain, it would be buying roughly 320 bln euros of Italian bonds and 115 bln euros of Spanish bonds. And this does not even address the efficacy of the Securities Market Program (SMP), which is to say that despite the ECB's purchases of Greek, Irish and Portuguese bonds did not arrest the increase in yields. The ECB may be enjoying a moment of victory today, but it is but a single battle in what promises to be a long war.

Fourth, the ECB ostensibly was willing to buy Italian and Spanish bonds today because over the weekend both made commitments to boost savings and accelerate fiscal efforts. However, in Italy's case, the this seems to be the wrong policy course. Italy's budget deficit this year is projected to be about 4.6% of GDP. This is among the smallest budget deficits in the euro zone and is below the euro zone's budget deficit as a whole of 6%.

It may be a bit counter-intuitive, but Italy's problem is not the overall level of debt either. It public sector debt is high, for sure, among the highest in the region. However, one of the key points we continue to hammer home is that public debt is only one part of the overall debt in a country. Overall, Italy's public and private debt combined is smaller than Germany and the UK for example.

Ultimately, the real problem in Italy is one of growth. Over the past decade, its growth has averaged less than 0.25% a year. Accelerating savings by a year and modifying the constitution to enshrine a balanced budget sounds good, but will do little to address the growth deficit.

Today as the ECB is buying Italian bonds, Italy's central bank revealed that its banks nearly doubled their borrowings from the ECB last month. During the first few years of the crisis, Italian banks were not large barrowers from the ECB. That changed last month as Italian banks borrowed 80.49 bln euros from the ECB after 41.32 bln borrowings in June. Moreover, as the ECB buys Italian bonds, Italy's top 2 banks have revealed that they reduced their Italian bond holdings by 20% in the H1 11.

There is a private sector campaign in Italy to promote domestic purchases of Italian bonds, but the ECB's purchases at first blush should be seen as filling the vacuum left by what may be considered a capital strike by some of the domestic banks.

While the ECB bond purchases have seen a dramatic response in the debt market, the CDS market is telling us another story. The roughly 50 bp decline in the Italian 5-year CDS price still leaves it higher than it was a week ago. The Spanish reaction is a bit stronger, but the 55 bp decline still leaves the 5-year CDS well above levels seen in the aftermath of the July 21 euro zone agreement.

For investors, this take away is that the ECB purchases of Italian and Spanish bonds is no panacea and the operation may aggravate liquidity and sterilization risks and do not appear to be convincing investors as judged by the CDS market. There is still the concern that in order to meet their own fiscal goals, Spain and Italy may be tempted to refrain from participating in international assistance of others (Greek 2.0) and that this would increase the burden on Germany and France, with the latter being ill-positioned to cope without putting at risk its own triple A status