ECB Considers Massive Purchases of Italian and Spanish Bonds (Update: Eurobazooka Armed)

Even thought the US media has been fixated on the downgrade of Treasuries to AA+ by Standard and Poor’s, the real risk to the markets is continuing decay in Eurozone sovereign debt. The BBC’s Robert Peston said today that the failure of the ECB to buy Italian bonds would be a Lehman moment. As our Ed Harrison stresses, while some countries like Greece have a solvency crisis and need to have their obligations restructures (as in written down), the stress on Spanish and Italian bonds looks like a classic liquidity crisis. And the concern has spread to the core, as French sovereign debt (remember, rated AAA) was trading at a 90 basis point premium to German bunds. As Ed noted:

The European Central Bank is now deciding how much liquidity to provide because it has received a quid pro quo from Italy that some analysts knew were necessary before the ECB would provide any liquidity….But clearly , since the ECB has unlimited liquidity it could backstop any and all euro-denominated debt issuance if it so chose. The questions now go to how much liquidity the ECB is willing to provide, how much moral hazard it is willing to risk, and what specific conditions it will require before it provides any liquidity at all.

The latest on the ECB from the Wall Street Journal:

European Central Bank officials on Sunday evening were weighing whether to purchase government bonds of Italy and Spain on a massive scale, according to people familiar with the matter, a move that would mark the most dramatic, and controversial, escalation of their nearly two-year effort to stem Europe’s unfolding debt crisis.

ECB intervention to prop up Italy and Spain would be a watershed in Europe’s effort to fight the financial crisis. The central bank has so far insisted that the main responsibility for acting lies with national governments. A decision to buy Italian bonds would be tantamount to accepting that the euro’s member states are unable or unwilling to respond effectively, turning the ECB into the lead firefighter—and the euro zone’s lender of last resort. That could change the nature of Europe’s monetary union.

Sunday’s meeting, which began in the early evening via a video conference, promises to be contentious. The 23-member ECB board was already divided along north-south lines on limited purchases of Irish and Portuguese bonds at the ECB’s meeting last week. At least three central bankers from Northern Europe, including the ECB’s powerful German contingent, resisted the move, the people said.

This is a much more important potential disruptor than the S&P downgrade, which is almost certain to hit stocks rather than Treasuries. Central banks have indicated, not surprisingly, that they will continue to hold Treasuries (note all the Chinese harrumphing contained no specific threat); big foreign money managers have also said that Treasuries are still the most appealing game in town for investors who need safety and liquidity. Wall Street banks confirm our view, that any selloff in Treasuries is likely to be temporary. There are lots of investors that are desperate for yield and any uptick would be welcomed and seized.

But that fact that we have had a debt deal put in place that is massively deflationary, and S&P (and to a lesser degree, Fitch) want further cuts means lower GDP growth and higher unemployment. And where is the place to be in deflation? High quality bonds and cash. Last week’s combination of a large rally in Treasuries, which were already trading at high levels with the debt ceiling negotiations, and falling stock prices, is exactly what you’d expect to see with investors waking up to the risks and consequences of deflation. A failure of the Eurozone to deal with a liquidity crisis induced by its lame response to the rolling solvency crisis in Greece would be another deflationary blow. It would be nice if we could carry off deflation as gracefully as Japan, but they have the social cohesion to settle on a model of shared sacrifice. Our version is certain to be more ugly.

Update 6:00 PM. Via Reuters(hat tip Richard Smith):

The European Central Bank said on Sunday it would “actively implement” its controversial bond-buying programme to fight the euro zone’s debt crisis, signaling it will buy Spanish and Italian government bonds to halt financial market contagion.

After a rare Sunday night conference call, the ECB welcomed announcements by Italy and Spain of new deficit cutting measures and economic reforms as well as a Franco-German pledge that the euro zone’s rescue fund will take responsibility for bond-buying once it is operational, probably in October.

“It is on the basis of the above assessments that the ECB will actively implement its Securities Markets Programme,” an ECB statement said.

The statement marked a watershed in the ECB’s fire-fighting efforts after modest bond-buying last week failed to stem contagion to the currency bloc’s larger economies.

The text of the ECB’s statement (hat tip the Economic Populist) is underwhelming but if you understand the code, it says the ECB is prepared to step up to the plate in a serious way. How aggressive its intervention winds up being remains to be seen. Investors have a nasty way of liking to test the resolve of parties that will hit their bid. The ECB is not operationally constrained, but it is still unduly worried about inflation in an obviously deflationary environment. So we will see altogether too soon how this plays out.

To put it another way: the Wall Street Journal has signaled what Mr. Market wants, massive purchases or at least a massive commitment. My readers of European press tell me that the signals this weekend was that the ECB wants to nibble only and is trying to prevent panic sales. If this reading is correct, this is a variant on the Paulson “bazooka” strategy of July 2008 with Fannie and Freddie, that if the markets knew he had a bazooka in his pocket, he would not have to use it. We know how that one turned out.

This post originally appeared at naked capitalism and is reproduced here with permission.