ECB faces tricky choice on rates

Ross Westgate
APPROPRIATELY, the European Central Bank holds its monthly policy-setting meeting in Barcelona this week. Not that it can do much to ease the pain of Catalan football supporters post Barca’s Champions League exit and the loss of their coach – but at least they’ll get a firsthand account of what’s going on at the frontline of Europe’s economic battleground.

On the face of it, market reaction to ratings agency S&P’s two notch downgrade of Spanish debt and news that nearly a quarter of the working population is now unemployed was very muted. But to anyone who’s looked at the numbers it was pretty clear which way the trend was going and, as S&P suggests, will continue to do so.

The Spanish government commented on Friday that it may have to put more money into the banking sector. They would aim to do so without resorting to Eurozone funds but plenty wonder if that’s feasible. If Spain did take aid from the EU, then bondholders face a risk of subordination, something definitely not in the price.

S&P’s Moritz Kraemer told me it would depend on where and when the money was taken. If from the European Financial Stability Facility, in place until July, there would be no subordination in the event of a default. But if they wait until the ESM has replaced it at the end of that month, it’s a different story.

Regardless of that time bomb, most if not all fixed income guests I interview expect yields on Spanish debt to have a sustained move higher, to well above six per cent. It would then be reasonable to expect the ECB to reopen its Security Markets Programme and restart the practice of buying peripheral debt in the secondary market. But the threshold for doing so might be quite a bit higher than some think.

In the meantime the ECB might help the periphery by holding rates as low as it can, even if it risks a reflationary boom for the core.

But Guy Monson of Sarasin says holding rates falsely low for prolonged periods always risks asset and investment bubbles, a fate that likely awaits Germany and possibly Switzerland, via the Swiss Franc “ceiling”.

As a result investors in real estate, exporters, insurance and perhaps even one day bank assets in those countries will ultimately benefit.

Ross Westgate co-hosts Worldwide Exchange daily from London and anchors Strictly Money on CNBC