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European Central Bank in bond buy-up

With US sovereign debt ratings downgraded piled on top of Europe's problems, the markets are still focused on short-term developments.

GLOBAL markets cleared a crucial psychological hurdle early yesterday evening in their search for stability when Italian and Spanish bonds rallied strongly on the back of European Central Bank (ECB) buying.

Yields on the debt of both countries fell by about three-quarters of a percentage point to less than 5.3 per cent in early European trading, a huge move. If sustained, it will buy the European Union more time to craft a stronger defence of the two nations, considered Europe's Maginot Line in the fight against sovereign debt contagion.

The European rally was reflected in Wall Street futures, where expected Wall Street losses were halved, albeit to a level that still showed a solid decline in the Dow Jones Industrial Average of 30 blue-chip US stocks.

Finance ministers in the G20 group also issued a statement declaring they would take "all necessary initiatives in a co-ordinated way" to stabilise the markets and foster economic growth. But with US sovereign debt ratings downgraded piled on top of Europe's problems, the markets are still focused on short-term developments.

The ECB support for the Italian and Spanish bond markets is mainly about sending a signal that the bonds were oversold and underpriced. Central bank buying cannot continue indefinitely and one fear in Europe is that the ratings agencies will now turn their attention to another AAA European economy France.

Another short-term hurdle was looming overnight in potential downgrades of widely held US municipal, or local government bonds, that are benchmarked against the federal credit rating that Standard & Poor's cut from AAA to AA plus on Friday.

Pimco, arguably the world's most influential bond investment manager, has told its clients, however, that the US government debt markets are "still the deepest and most liquid in the world".

It says America's obligation to service its debt is unaffected and the US Federal Reserve has told US banks that they do not need to support the downgraded US bonds with extra capital. The US dollar and US government paper will "still be the reserve currency and the safe asset due to the lack of an alternative".

Further out, the highest and most important hurdle looms, in the form of economic data that the US and Europe report in coming weeks and months. The sell-off was triggered in part by Washington's deal a week ago to negotiate an increase in its borrowing limit in return for spending cuts. But the key underlying concern is that the fiscal screws are being tightened at the same time as US economic growth is turning down before its rebound from the global financial crisis is secured.

One hope is that weakness in the June quarter reflected a manufacturing supply chain interruption caused by Japan's earthquake and tsunami. But if US growth is as weak as feared, the options are limited.

The US government has already agreed to cut spending, not increase it, as part of its deal to lift its borrowing limit, and the US Fed's key interest rate is already close to zero.

The fed meets tonight, our time. But its willingness to launch plan C is going to be tempered by its knowledge that even as the US economy struggles to grow, it is showing signs of reigniting inflation.


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