FRNKFURT (MNI) – The unexpected July drop in German manufacturing
orders may confirm the European Central Bank’s projection that the
Eurozone is heading for slower growth in the third quarter.

Meanwhile, news of still rising ECB borrowing from Portuguese banks
and spiraling peripheral bond spreads suggest that the central bank may
have to uphold non-standard liquidity support measures possibly well
beyond the first quarter of 2011.

German manufacturing orders contracted by 2.2% in July, upsetting
expectations for a modest increase, following a rise of 3.6% in June.
The detailed breakdown showed that the decline was largely driven by
foreign orders (-4% m/m), possibly raising fears that the global
slowdown is beginning to bite.

Excluding volatile bulk orders, however, new orders were up 0.6%
m/m, signaling ongoing expansion albeit at a slower pace than during the
exceptional second quarter. This would be in line with signals from the
latest manufacturing PMI that showed new orders fell 5.9 points to 57.4.
It should also be broadly in line with the ECB’s base scenario.

The bigger concern for the Governing Council should be news that in
August Portugal’s banks once again stepped up their borrowing from the
ECB, suggesting they remain heavily dependent on central bank money.
Borrowing rose by 0.6% to a record of E49.1 billion. Details for other
peripheral countries for the month of August are not yet available.

The stubborn dependency of individual banks on ECB cash,
particularly in the periphery, has forced the central bank to slow its
exit from non-conventional support measures even as overall money market
conditions continue to improve. Latest data from Portugal suggest that
extra liquidity support may well have to be extended again beyond the
current schedule of late-January 2011.

Thursday’s decision by the Governing Council to keep supplying
unlimited liquidity at 1-week, 1-month and 3-month maturities leaves
little doubt that the central bank will not abandon its support as long
as it remains the sole lifeline for some banks — especially since those
banks are so heavily concentrated in the countries that were at the
epicenter of the recent sovereign debt crisis.

Latest media reports suggest that banking problems may indeed be
more widespread than previously expected.

On Tuesday, The Wall Street Journal published a report saying that
European bank stress tests underestimated the exposure of some major
banks to sovereign debt. A report in Germany’s Der Spiegel magazine said
German banks could need to raise over E100 billion in new capital.

Recrudescent fears about the health of the Eurozone’s banking
system coupled with ongoing concerns over Ireland’s cost of bailing out
Anglo Irish sent Eurozone peripheral bond spreads spiraling again.

Irish bond spreads and yields rose above the peaks reached at the
height of the sovereign debt crisis in early May. The spread between the
benchmark 10-year Irish bond and the German Bund was 375 basis points
earlier today. The Portuguese-German spread reached a record 355 basis
points, while the Greek-German 10-year yield spread reached 947 basis
points.

According to market rumors, the ECB was active in the market,
buying up Eurozone government bonds through its Securities Markets
Programme. As previously, the amounts bought are said to be limited.
Nevertheless, the central bank is unlikely to want to give up its sole
tool of addressing bond market tensions as long as market jitters
persist.

The twin evils of the sovereign debt crisis and the banks’
dependency on ECB cash are likely to keep the central bank in
non-standard mode for months to come.

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

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