Bond Yields Reverse as ECB Steps Up

The European Central Bank stepped in to counter a bond rout on Wednesday, helping European shares and the bonds of weaker euro-zone countries recover on the day Italian Prime Minister-designate Mario Monti is to name his national unity government.

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They’re heavily in on Italy and Spain, 2-10 years,” one trader said of the central bank intervention. Yields on Italian government bonds fell just below the 7% danger level that required other euro-zone countries to seek bailouts, including Greece, Portugal, and Ireland.

However, ECB policymakers continue to refuse any decisive action on their part to stem the sovereign debt crisis by becoming Europe’s lender of last resort, stressing that it is up to governments to resolve the debt crisis through austerity measures and reforms.

In the meantime, bond market contagion seems to have spread to the euro zone’s second-largest economy, France. The risk premium investors charge for holding French debt rather than benchmark German 10-year Bunds hit a euro-era high on Tuesday, above 190 basis points.

Despite numerous calls from world leaders for Europe to act more boldly to combat the debt crisis, there is no sign that Wednesday’s bond-buying signaled a change in the ECB’s policy of limited, stop-go purchases meant to temporarily stabilize markets while maintaining pressure on governments to reform spending.

Today’s respite might be short-lived, as U.S. policymakers have voiced alarm at growing signs of strain in the money market. Banks in the euro zone face increasing difficulties in obtaining dollar funding despite ECB moves to provide unlimited liquidity to banks.

“Markets are clearly expecting a circuit breaker to alleviate pressure on periphery bond yields,” said David Scutt, a trader at Arab Bank Australia in Sydney. “If no announcement is forthcoming in the days ahead, one suspects that the situation could unravel fairly quickly.”

Many analysts believe that the only way to stem the contagion now is for the European Central Bank to buy large amounts of bonds in the sort of quantitative easing undertaken by the U.S. and British central bank.

Though Germany has objected to expanding the ECB’s role, Peter Bofinger, a member of the group of economists that advises the German government, believes the ECB should indeed become the euro zone’s lender of last resort.

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“If politics can’t do it, then the ECB must do all it can to bring interest rates down to more reasonable levels,” Bofinger said at Euro Finance Week.