A rush of demand for bonds of two of Europe's financially stretched governments marked a rare day of investor confidence in the continent's quest to contain its fiscal woes.
Italian and Spanish debt auctions on Thursday were great successes as borrowing costs for both countries fell sharply, while European Central Bank president Mario Draghi said the 17-country euro zone is seeing "tentative signs of a stabilization in economic activity," albeit at low levels.
The cheery news sent the euro up almost 1 per cent against the U.S. dollar. Commodities climbed, though European stock markets closed down slightly.
But the sudden appetite for government debt has more to do with the ECB's record injection of €489-billion ($638-billion) in cheap funding into the banking system last month than with austerity measures and economic reforms in Spain and Italy.
The ocean of new liquidity gave the banks the ability – and the confidence – to buy sovereign debt in the hopes of making a profit. The banks can borrow three-year money from the ECB at 1 per cent and buy sovereign debt with similar maturities that pay much higher rates – the so-called carry trade. French President Nicolas Sarkozy had been urging the banks to buy sovereign debt.
Mr. Draghi, who left the ECB's benchmark rates unchanged on Thursday at record lows, did not comment on the banks' roles in the Italian and Spanish debt auctions. He did, however, say that the loan injections to the banking system "indicates that our non-standard policy measures are providing a substantial contribution to improving the funding situation of banks, thereby supporting financing conditions and confidence."
Italy was the star of Thursday's debt auctions. Rome sold €12-billion of one-year notes at a yield of 2.73 per cent, less than half of the 5.95 per cent demanded by skittish investors at a similar auction in mid-December. Spain sold €10-billion of bonds that mature in 2015 and 2016, twice its target. The yield on the 2015 paper was 3.84 per cent, compared with a hefty 5.18 per cent at the December auction.
The successful Italian and Spanish debt auctions, however, may not mean the worst is over for the two hard-hit countries, whose economies are almost certainly back in recession. Relatively short-term debt, like the bonds sold by Italy and Spain Thursday, is generally easier to push out the door than longer-term debt. Investors, notably the banks, may not be so ready to take credit risk of, say, 10-year bonds, especially since the ECB's cheap loans extend for only three years.
Yields on Italy's benchmark 10-year bonds fell about 40 basis points Thursday, to about 6.6 per cent (100 basis points equals one percentage point). But the new level remains firmly in danger territory and Italy has to raise a massive amount of debt – about €450-billion in gross terms – this year. With €1.9-trillion of debt, and a debt-to-gross domestic product ratio of 120 per cent, Italy is Europe's most indebted country.
The debt loads of Italy and other struggling countries could easily rise as the euro zone slips into recession. While Mr. Draghi seemed cautiously optimistic that the economy had not substantially deteriorated since November and December, when he cut rates twice, each time by 0.25 per cent, he did not say the worst was over for the debt crisis or economic growth threats.
Economists and investors still expect more ECB rate cuts because of the slowing economies and because inflation pressures appear to be on the wane (Mr. Draghi said euro zone inflation should dip below 2 per cent later this year). Mr. Draghi said the "economic outlook remains subject to high uncertainty and substantial downside risks" in spite of the tentative stabilization signs.
Carsten Brzeski, European economist at ING Bank, said the ECB is ready to swing back into action after Thursday's pause if the euro zone economies deteriorate. "With the main interest rate at 1 per cent and the enormous liquidity measures, the ECB remains ahead of the curve and has room to react if need be," he said. "No doubt, the ECB will not hesitate to use it."
A big risk to growth and sovereign bond yields is Greece, the potential default on its debt and the country's possible withdrawal from the euro zone. Some economists expect Greece to default this year.
Mr. Draghi would not comment directly on Greece's predicament, though he urged the country to complete its planned fiscal reforms and reiterated his criticism of the "private sector involvement" – or PSI – which would see banks and other private investors take a 50-per-cent "haircut" on their holdings of Greek debt. The effort, unveiled last summer, has been blamed for triggering a run on debt in other countries, such as Italy. "PSI was an understandable political response, but it had unintended consequences," Mr. Draghi said, arguing that the effort "went over and above any expectation at the time."
Speaking at a conference in Paris on Thursday, David Riley, the head of global sovereign debt ratings at Fitch, called PSI in Greece "frankly a disaster."