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Why Draghi Disappointed Bond Investors

The ECB may do “whatever it takes” to keep bond markets intact, as its president promised a few days ago, but now he says it will take its time doing so.

Mario Draghi, president of the European Central Bank, left bond investors crestfallen and fearful on Thursday by revealing that he has dug a new line of defense for debt markets, which is much further from the front line than its predecessor.

He will endorse bond buying to aid troubled peripheral euro zone countries only after they have formally requested a bailout by the euro zone — setting a strict new condition to salvation.

Draghi’s assertion suggests the ECB has adopted a considerably less preemptive approach than its proactive practice earlier this year, when it stopped Italian and Spanish bond yields from escalating out of control by shoring up their bond prices without the trigger of official bailouts.

Because of this more conservative stance, yields may rise to considerably higher levels than they have in the past before intervention brings them back down again.

Draghi spelled out the details of his new approach after the bank’s monthly monetary policy meeting on Thursday. In line with his comments last week that the ECB would do “whatever it takes” to preserve the euro, he said the central bank was prepared to buy member states’ bonds to take yields lower. However, the state must first apply for aid to the euro zone’s rescue funds — the European Stability Mechanism and European Financial Stability Facility. This move — to be considered “when exceptional financial market circumstances and risks to financial stability exist,” required “strict and effective conditionality.” The “appropriate modalities” for these purchases would be worked out by the bank “in the coming weeks.”

In practice, this more stringent demand means the ECB is likely to take much longer to intervene in bond markets than it did earlier this year, when it bought the bonds of Italy, Spain and other troubled euro zone economies.

In the case of Italy and Spain, the ECB last year secured national governments’ agreement on austerity measures before agreeing to buy bonds under the ECB’s Securities Market Program. However, these agreements were informal, and therefore relatively easily and rapidly given.

A formal application to the rescue fund would take longer. Countries might in practice only resort to it once yields on mid- and longer-term bonds were rapidly escalating out of control and towards double digits — rather than the 6 or 7 percent or so for 10-year issues at which the ECB has intervened in the past to aid Italy and Spain.

This delay is likely for several reasons. National governments will be reluctant to accept the much greater stigma of a formal bailout unless they are in irrevocably desperate straits. An official bailout will tie their hands much more than the sort of informal bargaining which Italy, under premier Silvio Berlusconi, largely wriggled out of last year. Finally, for any new countries that suddenly find themselves in trouble, any formal application for aid will inevitably take longer to put together than the unofficial emergency pacts agreed to with Italy and Spain in 2011.

The slow progress of current discussions between euro zone institutions and troubled member states confirms such obstacles: Mariano Rajoy, the Spanish premier, and Mario Monti, who has replaced Berlusconi as Italy’s prime minister, are reluctant to accept the stringent conditions of an official euro zone rescue.

But although this second line of ECB defense may be set back much further, there are signs that it has at least been dug deeply. Unusually for an ECB president, Draghi revealed on Thursday that one member of its Governing Council had opposed the decision to resume bond purchases. He hinted that this hostility came from the powerful Bundesbank, which has publicly expressed qualms about the ECB’s buying of debt.

This revelation of internal opposition to further bond-buying has the counterintuitive effect of indicating that further bond-buying is likely to take place if the right conditions are met: Draghi was signalling that he is prepared to ignore the Bundesbank’s disquiet.

“It’s clear and it’s known that Mr. Weidmann and the Bundesbank have their reservations about the program of buying bonds,” Draghi said on Thursday. However, once the new purchasing program has been designed, the ECB “will take a final decision and the votes will be counted.” Weidmann is the Bundesbank’s head.

The ECB’s president also hinted at another consolation prize for markets — that the ECB may no longer demand seniority over private investors when bailing out member states in the future.

Many institutional investors are all the more reluctant to buy the bonds of peripheral states, because of their bitter memory that when Greece’s default was negotiated earlier this year, the ECB preserved the full principal value of its Greek bonds by insisting on much more niggardly recovery of principal by private investors.

Draghi said on Thursday: “The concerns of private investors about seniority will be addressed.”

However, his reassurance about bond seniority left investors underwhelmed, since it stopped short of saying the ECB would accept the same losses as other bondholders.

“Draghi created unrealistic expectations but failed to announce concrete measures significant enough to reassure investors,” said Stephanie Kretz, London-based strategist at Lombard Odier, the Swiss private bank. “One unintended consequence might be that next time the ECB wants to calm markets, his words won’t carry the same effect.”

Sell-offs in risk assets sent the euro down 0.5 percent on the day to $1.216 in New York afternoon trading, with the Eurofirst 300 index of euro zone equities down 1.2 percent to 1,055. The yield on Spanish 10-year bonds leapt 24 basis points higher to 6.99 percent.

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