FRANKFURT (MNI) – The European Central Bank’s failure to reassure
markets that it has a handle on what is rapidly becoming a full-scale
Eurozone debt crisis is forcing an increasingly intense confrontation
with markets and overshadowing positive data emerging from the
Eurozone’s stronger economies.

The widening in recent days of spreads on Greek debt and,
increasingly, on the securities of other peripheral EMU states has
revealed yet again that markets are not convinced the troubled Hellenic
Republic can restore its fiscal position without default or debt
restructuring. And they are not reassured by the repeated insistence of
European authorities that there’s no reason to fear contagion to
countries like Portugal and Spain.

From the market’s point of view, the bad genie is out of the
bottle: the contagion is already happening. The market is making sure of
that.

That’s despite the successful conclusion last weekend of a E110
billion three-year rescue package for Greece to be provided in tandem by
the Eurozone member states and the International Monetary Fund.

Markets had been hoping that ECB President Jean-Claude Trichet
would at least hint on Thursday that the central bank had given some
thought to the idea of buying Eurozone government bonds to underpin the
troubled Eurozone peripheral-bond market.

He did exactly the opposite: “We did not discuss this option,”
Trichet insisted. “We did not discuss the matter, and [I've got] nothing
else to say on that,” he added for emphasis.

The markets reacted with a fury: The euro tumbled, peripheral vs.
German spreads widened, U.S. equities — aided somewhat by human error
— nosedived.

There is no doubt: a European sovereign-debt crisis is upon us and,
judging by analysts’ comments following the ECB press conference
Thursday, the central bank may be forced to delay monetary tightening
until well into next year — and perhaps even dare to consider the
unthinkable prospect of purchasing government bonds.

For European bulls it is a pity that the debt crisis is
intensifying now, just when the most recent data is showing that the
Eurozone recovery is solidifying.

On Thursday, German manufacturing orders outdid even the most
optimistic expectations, growing 5.0% on the month in March. On the
quarter, new orders were up 6.5%. Sentiment indicators such as Ifo and
the PMIs are pointing to further gains ahead.

Also encouraging are the March German industrial production
figures, published Friday: the 4.0% monthly gain surpassed all
expectations. These data underpin the consensus view that although the
German economy suffered a — largely weather-induced — setback in the
early months of 2010, it is fundamentally still moving forward.

Yet, the reality is that these results are dwarfed by the
relentless, and now spreading, Greek saga. And one could credibly argue
that there is a dark side to the strong German data: they lay bare the
unpleasant reality of a two-speed Europe, with the big German machine
rapidly pulling away from the Eurozone’s less stellar economies.
Arguably, that divide is ultimately what’s behind the crisis to begin
with.

Markets, nearing panic mode, want the ECB to take aggressive
action. They want the ECB to purchase the government bonds of troubled
EMU states, thus underpinning demand for them and narrowing the spreads
while taking them off the balance sheets of European banks.

Many observers, however, do not envision the ECB doing this. In the
first place, bond purchases on the primary market violate Eurozone
rules. So such a program would have to be conducted through the
secondary market.

But even secondary market purchases would put the bank’s
independence at risk, confusing monetary policy and fiscal policy. By
selecting the securities of some states and not others, they would open
themselves up to the charge of monetizing debt, essentially financing
government deficits.

Moreover, flooding the markets with liquidity just as inflation is
starting to rebound would clearly contravene the bank’s sacrosanct
mandate of preserving price stability.

In principle, purchasing government bonds would seem untenable to
the ECB. But the way the bank has acted in recent times, one can no
longer assume that conventional wisdom will hold. The central bank’s
decision on Monday to accept all Greek paper as collateral, regardless
of its rating, completely contradicted its earlier assurance that it
would not change its rules to accomodate one member state.

There is no way to know what the bank has planned next, but if
market sentiment does not start to change soon, the ECB might be forced
to contemplate something radical.

It could re-start some of the unconventional measures that it has
recently jettisoned, such as the 12-month and 6-month refinancing
operations. Yet it is unclear whether markets would view that as
sufficient.

Either way, these are very tense times. At the moment, markets are
driving right at the ECB in a very high-stakes game of chicken. Nobody
can say how it will end, but the chances of the ECB doing the
unthinkable are considerably higher today than they were even one week
ago.

–Frankfurt newsroom +49 69 72 01 42; Email: tbuell@marketnews.com

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