* This piece was written prior to Italy's auction of 10-year bonds.
There were small but as-yet inconclusive signs last night that the European Central Bank’s backdoor attempt to do what its mandate prevents it from doing directly might be working. More substantial evidence will be available tonight.
Last week the ECB did something unprecedented when it lent European banks €489 billion of three-year money at a meagre one per cent interest rate. The strategy appears to have been not just to flood the banks with liquidity but to encourage them to enter into carry trades that would ease the credit crunch in sovereign debt markets.
The ECB can’t buy sovereign debt directly but it appears to have hoped the banks would do so on its behalf, borrowing from it at one per cent to invest in their governments’ debts and collecting a 300 or 400 basis point margin in the process.
At face value the strategy failed, with the banks promptly depositing €452 billion with the ECB – and earning a loss-making 0.25 per cent on those funds. In effect, the banks are paying the ECB to protect their liquidity rather than accept any level of risk.
There was, however, a glimmer of something hopeful. Last night Italy was able to sell €9 billion of six-month Treasury bills and €1.76 billion of two-year zero coupon notes. The bills were sold on a coupon of 3.25 per cent – half the rate Italy had to pay for a similar issue only a month ago. The notes sold at 4.85 per cent, compared with the 7.81 per cent the market demanded for a similar issue in November.
The flow-on effect of the issues was seen in an immediate 25 basis point fall in Italy’s 10-year bond rate, to 6.75 per cent, although that decline was retraced in later trading and the 10-year bond rate remained at the 7 per cent level that is regarded as the threshold for an unsustainable cost of sovereign borrowing.
The successful issues, and the dramatic fall in their cost, could be regarded as both a tick for the €30 billion fiscal reform package Mario Monti’s government passed in parliament last week and a small sign that some of the ECB’s funds were being used in the fashion it appears to have hoped for.
The larger, far more important, test comes tonight when Italy will try to sell €8.5 billion of three-year, seven-year and 10-year bonds.
The trading in the 10-year bonds last night suggests that it is unlikely there will be the same steep falls in the cost of funds experienced with the shorter maturities that are needed to reduce the impact of the debt-servicing burden on an economy which will be forced deeper into recession by the austerity measures. Italy has about €1.9 trillion of sovereign debt.
With Italy needing to raise about €450 billion from bond and bill issues next year, a big chunk of it in the first quarter, the outcome of tonight’s issues will set a critical tone for the eurozone and its prospects of somehow muddling its way out of the crisis, or at least buying some time to come up with a more convincing plan than the succession of half-measures that have so far exacerbated the markets’ fears and the financial impacts of them on governments and banks.