Bond markets rally as ECB moves on Italian and Spanish debt

The European Central Bank (ECB) has broadened its bond purchase programme to include Italian and Spanish paper, in a bid to ease market tensions and stave off the threat of contagion.

The ECB refused to confirm or deny whether it had purchased Italian and Spanish debt through the bond buying programme. However, analysts who spoke to CentralBanking.com said it was clear the ECB was taking "large positions" in Italian and Spanish paper.

In a statement released on August 7, the ECB's Governing Council says it welcomes the new fiscal reforms and structural measures agreed by Italy and Spain, adding that a decisive and swift implementation of the measure would rapidly reduce public deficits. In light of these events, and the current "exceptional" circumstances in the financial markets, the eurozone central bank says it will implement its Securities Markets Programme.

After hitting a peak of 6.22% on August 5, yields on 10-year Italian government debt fell 75 basis points on August 8 to 5.33%. Spanish yields also moved lower, with 10-year debt down 80bp to 5.24%, well below the 6% level it was trading above last week. However, European equity markets continued to post losses, with the FTSE 100 and Dax, the main stock exchange index for London and Frankfurt, down 2.15% and 2.84% respectively.

Macro strategist Nick Stamenkovic from RIA Capital Markets, a brokerage based in Edinburgh, says the move by the ECB signalled a determination to draw a line in the sand between Italy and Spain and the other peripheral countries. "Essentially, the ECB will support those sovereigns that implement measures to reduce the budget deficit and ensure fiscal substantiality over the medium term," Stamenkovic tells sister publication CentralBanking.com.

On Friday, Italy's prime minister, Silvio Berlusconi, agreed to press on with a €40 billion ($56.95 billion) austerity package and bring forward the government's target to balance the budget by a year to 2013. Spain has also embarked on a fiscal austerity package that will see Madrid cut its deficit to 6% of gross domestic product, from 11.1% by the end of 2011.

Stamenkovic says by buying Italian and Spanish debt, the ECB was providing a "back stop" for bond markets until the European Financial Stability Facility (EFSF) was up and running. However, he says even once Germany and France ratifed the agreement to expand the EFSF's powers, the size of the EFSF would need to be increased to provide sufficient "fire power" for Italy and Spain in the coming months.

The euro fell 1.77% against the Swiss franc and traded at €0.929 at 4.45pm UK time.

Last week, yields on Italian and Spanish debt surged to their highest levels since the euro was created in 1999, after a €109 billion ($155 billion) bail-out package for Greece failed to contain the sovereign debt crisis. In particular, concerns over the limited size of the EFSF and its capacity to provide financial assistance for Italy and Spain in the near term sparked widespread panic across equity markets. Eurozone governments are expected to pass legislation in September that will enable the EFSF to buy bonds on the secondary market.

Marchel Alexandrovich, the senior European economist at Jefferies, an investment bank based in London, says the ECB had made up for an earlier mistake that limited their purchases to debt from Ireland and Portugal. However, he says the unwillingness of Germany to take more risk by buying periphery bonds could cause problems in the future. "In the near term, markets got what they wanted. The issue that concerns me is that, in order for the whole process to be effective, the ECB will have to take on an enormous amount of debt on its balance sheet and the scale of the intervention will need to be beyond what Germany is willing to commit to."

Alexandrovich says, were the ECB to make the same amount of purchases as a percentage of total debt holdings – as it did for Greece, Portugal and Ireland – the Securities Market Programme would have to buy an estimated €300 billion ($426 billion) in Italy and Spain combined.

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