DESPITE new technocratic governments taking the helm in Greece and Italy, financial markets remain on edge regarding the future of Europe’s monetary union. Serious fiscal reform is unlikely to quickly take hold and may face very stiff opposition from populations already suffering from serious economic hardship. Meanwhile, the European Financial Stability Facility (EFSF) bailout fund is turning out a to be a colossal failure, leading many market analysts to conclude that the European Central Bank (ECB) is the only institution in Europe that can stabilise the region’s credit markets in the short term.
The latest strategy call is for the ECB to announce explicit ceilings on peripheral debt yields (say a 200 basis points premium for Italian BTPs to German bunds) that would effectively put an end to further deterioration in credit prices, allowing the countries to refinance their debt at reasonable rates for the foreseeable future. Having seen the recent success of the Swiss National Bank (SNB) at keeping the exchange rate of the euro-Swiss franc above the SFr1.2000 mark for more than two months, many market participants believe that similarly explicit intervention tactics by the ECB would put an end to the daily short selling assaults on Eurozone periphery bonds.
It is clear from the Swiss experience that monetary authorities achieve much greater respect from the markets and produce much more efficacious results when they communicate specific target levels, rather than simply providing ad hoc support. Few speculators are willing to challenge the unlimited buying power of central banks, and the mere threat of such endless liquidity would prevent the market from testing the resolve of the authorities. Especially since short positions in peripheral debt bonds carry a stiff daily penalty of negative interest costs and are predicated on the quick collapse in values of the instruments.
However, ECB officials are doing everything in their power to undermine this proposal for stabilisation, by making conditional threats regarding the future purchases of Italian bonds and emphasising that the ECB will not be the lender of last resort. As long as the ECB refuses to fully commit to the Eurozone credit market, the euro-dollar will continue to suffer death by a thousand cuts.