The European Central Bank is edging toward a bond-buying programthat investors say could end up printing money, echoing efforts bythe Federal Reserve and other central banks to fix a credit crisisnearing its sixth year.

ECB President Mario Draghi yesterday left open the question onwhether the bank would neutralize future bond purchases, a step ithas taken with all of its interventions to date. He also said thesize of the new program would be “adequate to reach its objective”of curbing Italian and Spanish borrowing costs, a contrast with the“limited” scope of the previous approach.

“You shouldn't assume that we will not sterilize or sterilize,”he told reporters in Frankfurt. Spanish and Italian bonds slumpedas Draghi steered clear of spelling out all the full details of hisplan, which is being resisted by Germany's Bundesbank. Spain's10-year borrowing cost jumped 17 basis points to 7.33 percent at8:17 a.m. London time.

“Bit by bit over the past two years, the ECB and all of theeuro-region governments have been capitulating,” said NeilWilliams, chief economist at Hermes Fund Management, which oversees29.3 billion pounds ($46 billion) of assets, including governmentbonds. “I sense from Draghi's comments he is inching toward QE andnow trying to get other ECB members to sign that off. It seems tome inevitable.”

The Fed bought $2.3 trillion of mortgage and Treasury debt from2008 to 2011 in two rounds of so-called quantitative easing to capborrowing costs. The ECB has bought about 220 billion euros ($268billion) of European government debt through the Securities MarketProgram it announced in May 2010, though it sterilized thosepurchases by taking the cash back as deposits to avoid stokinginflation, and hasn't used the SMP since March.

Draghi said “risk premia” in the bond market “need to beaddressed in a fundamental manner,” and details of the plan wouldbe fleshed out in coming weeks in consultation with governments.“It is clear and it is known that Mr. Weidmann and the Bundesbankhave their reservations about programs that buy bonds,” Draghisaid, referring to Jens Weidmann, head of the German centralbank.

The ECB said July 31 that it drained 211.5 billion euros inseven-day term deposits to neutralize the liquidity created by itsgovernment bond purchase program. About 72 banks submitted bidstotaling 463 billion euros, up from 397.5 billion euros at aprevious operation. The marginal rate on the term deposits was 0.02percent.

“It does seem that the ECB is inching closer towards pushing thebutton on some version of QE, though details are still somewhathazy,” said Craig Veysey, head of fixed income at PrincipalInvestment Management Ltd. in London, part of Sanlam Group, whichoversees $72 billion.

'Pyrrhic Victory'

Draghi said that any bond purchases would focus on short-datedsecurities, leading Spanish and Italian notes to outperform. Theyield difference between Spain's two-year notes and 10-year bondswidened 17 basis points to 254 basis points, the most since May.The so-called spread between Italian two- year and 10-yearsecurities reached 276 basis points, the most since March.

Spain's two-year yield is 4.77 percent, down from as high as7.15 percent on July 25, though up from a one-year average of 3.77percent.

ECB purchases would “encourage heavier issuance at the front ofthe Spanish and to a lesser extent Italian curves,” said MarcOstwald, a strategist at Monument Securities in London. That risks“exacerbating already burgeoning refinancing issues in the nextcouple of years, thus quite possibly a pyrrhic victory,” he wrotein a research note.

Draghi said countries would have to request help from theEuropean Financial Stability Facility, the euro area's temporarybailout fund, as a “necessary condition, but it's not a sufficientcondition” for help in curbing bond yields. That would produce amemorandum of understanding ensuring governments don't shirk theireconomic responsibilities, according to Mohit Kumar, head ofEuropean fixed-income strategy at Deutsche Bank AG in London.

“You can definitely say the argument for not doing the Fed-styleQE has weakened now,” Kumar said. “It's all about moral hazards.The ECB was reluctant to do a Fed-style bond purchase because it'sconcerned the approach will reduce pressure on troubled peripheralcountries to reform. Now an MOU is required before the ECB canintervene and it's likely to keep pressure on these countries.”

Serious Progress

The yield premium investors demand to lend to Spain rather thanGermany for 10 years rose to as much as 605 basis points from 536on Aug. 1. The average this year is 423. Italy's 10-year yieldpremium to bunds jumped 54 basis points since Aug. 1 to 510.

“Whatever the short-term gut reaction of markets, the ECBannouncement constitutes serious progress,” Holger Schmieding, thechief economist at Berenberg Bank in London, wrote in researchnote. “The ECB explicitly vowed to do what it takes to achieve itstarget and suggested that it may not sterilize the liquidityinjection. In a way, this is a cross of outright quantitativeeasing and the successful announcement of the Swiss National Bankto do everything to defend a cap for the Swiss franc exchangerate.”

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