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Eurozone Update: Latest ECB Plan A Significant Positive

ECB President Mario Draghi recently sketched out a plan that could be a significant positive for the Eurozone periphery. However, it will not solve the underlying causes of the Eurozone crisis, such as competitiveness imbalances, fiscal deficits, and excessive debt, and several risk factors remain. The following reflects the views of T. Rowe Price sovereign credit analyst Ken Orchard as of  August 10, 2012.

The new ECB plan is a significant positive for the periphery…


Draghi's proposal to Spain and Italy – request a financial support program, sign a memo of understanding, and implement tough fiscal and structural reforms – is compelling. In return, the European Central Bank will anchor the short end of the sovereign yield curve so that the governments can continue issuing bonds. The ECB is also considering other non-standard policy measures to ease the flow of credit to the private sector. This should lead to a general reduction in risk and lower Spanish and Italian yield spreads.

Draghi's plan addresses two of our greatest concerns: the current high interest rates/low-growth trap that makes deficit reduction and economic adjustment extremely difficult, and Spain and Italy's need for official external financing to replace the withdrawal of private sector capital.

…But the plan has short- and long-term drawbacks

Spain and Italy are reluctant to surrender their economic sovereignty. While the governments' opposition to a bailout program has diminished, some hope that the existence of the plan will sufficiently reduce yield spreads so that a formal request for assistance becomes unnecessary. This could keep periphery yield spreads volatile over the next month or so – at least until Spain throws in the towel.

The plan does not solve the underlying causes of the eurozone crisis. The ECB cannot solve the competitiveness imbalances, fiscal deficits, and excessive debt levels that make the crisis so pervasive. The eurozone's future will be uncertain until those problems are sufficiently resolved. Nevertheless, the plan should buy some time for the countries to have a decent chance at resolving their problems.

Spanish and Italian bond yields have probably passed their cycle peaks

Short-term Spanish and Italian bond yields have fallen significantly over the past few days, causing their yield curves to steepen. The curves are now back to levels seen in March 2012 – not long after the ECB's second long-term refinancing operation at the end of February – when both short and long yields were around 150 basis points lower. This is the steepest the curves have been in the euro's history.

Short-term Spanish and Italian bond yeilds

Given the uncertainty around rescue program requests, yields could be volatile over the next few weeks as the markets and sovereigns feel out each other's positions. Eventually, we think long-term Italian and Spanish bond yields will follow short-term yields lower. The ECB wants to eliminate uncertainty about the euro's future and fix the monetary policy transmission mechanism (i.e., reduce private sector interest rates). Current spreads for Italy and Spain are inconsistent with such a reduction in financial stress.

Eurozone stress should decline, but five risks need to be watched:

– Reprinted from Price Points, Insights from T. Rowe Price

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