Euroggedon postponed again as ECB gains three weeks

ECB president Jean-Claude Trichet

Euroggedon is postponed again. Jean-Claude Trichet has saved civilization. There will not be a spiralling bond crisis in Italy and Spain in early August after all. An imminent disintegration of Europe’s financial system has been averted.

On balance, this is good, though not optimal. (Lancing the boil immediately by organising an orderly German exit from EMU would be better: it would halt the Fisherite debt-deflation spiral in Club Med and clear the way for recovery.)

Spanish 10-year yields dropped 85 points to 5.2pc, Italian yields fell 76 points to 5.32pc in the first hour or so of trading after last night’s announcement.

Now for the hard part. Unless the ECB is willing to back up its new role as lender-of-last-resort with massive purchases of Italian and Spanish debt, it will inevitably be tested by markets. Weak hands will take advantage of rallies to offload holdings onto the ECB, i.e. onto eurozone taxpayers. Frankfurt will find itself underwater very quickly without a legal mandate or EU treaty authority.

RBS calculates that the ECB will have to buy roughly half the outstanding tradeable debt of the two countries to defend the line. RBS calculates €850bn. I would put it nearer €1 trillion.

This is currently impossible. The ECB is acting as a temporary back-stop until the revamped EFSF bail-out fund is ratified by all parliaments over coming months. The EFSF will then take the baton.

Yet as we all know, the EFSF has no money. The parliaments have not even ratified the earlier boost to €440bn. As of today, the fund has barely €80bn left after all the commitments to Greece, Ireland, and Portugal. It remains a fiction.

As for boosting it further to €2 trillion or more – as suggested by Citigroup, RBS, and the European Parliament – we face a little local difficulty across the Rhine. Bavaria’s Social Christians said they will not back one bent Pfennig for extra bail-outs, and the FDP Free Democrats are almost of the same mood. Angela Merkel’s CDU base is more mutinous by the day. In any case, such an expansion of the EFSF would set off its own chain-reaction as France and then Germany lost their AAAs and slithered into the swamp.

So, obviously markets will turn very nervous once ECB purchases approach the level that corresponds to the EFSF ceiling. They know that the ECB’s Teutons will die in a ditch rather than cross that line, taking the bond risk directly onto the ECB’s own balance sheet.

That moment could come within three weeks.

Gary Jenkins from Evolution Securities notes that Greek yields fell from 12.43pc to 7.35pc in the week following the ECB’s first bond purchases, only to fly out of control six weeks later.

Good template.

Whether buying time can solve anything depends on whether investors believe that Italy and Spain can grow their way out of debt traps. If we are on the cusp of a new global boom, then Italy and Spain can make it within EMU’s current structure.

If we are going into a global double-dip (defined as global growth below 2.5pc), they have no chance at all unless the ECB throws all caution to the wind, defenestrates the two German members from the 36th floor of the Eurotower, and embraces QE a l’outrance.

Germany might not like that.

I have a nasty feeling that nothing whatsoever has been resolved.