The governments went as far as they could, technically and politically. From their point of view, the timeline is now incompressible (if only because the German parliament likely wants to await the Constitutional Court ruling - due around mid-September - before enacting any new legislation). Speeding up the implementation of EFSF 2.0 is therefore unlikely. This leaves the ECB alone in being able to respond to any further deterioration in market conditions.

Whatever happens, the ECB's balance sheet will probably be put at further risk. Indeed, as a mechanical reaction to the increase in long-term sovereign rates, margin calls at LCH Clearnet will probably push Spanish and Italian banks back to the ECB refinancing, using local sovereign bonds as collateral (good carry).

The ECB would have three options, in our view:

a) Doing nothing. By simply maintaining the current LTROs and MROs in their present conditions, the ECB allows for indirect financing of the governments (via banks). However, this cannot last forever: if interest rates continue to rise, the central banks will have to trigger margin calls, which at some point will significantly erode the profitability of the peripherals' banks. The Greek, Irish and Portuguese experiences are not very encouraging from that point of view.

b) Embrace indirect financing of governments by reinstating the 12-month LTRO. In Focus Europe eight months ago ("What is Plan B", 3 December 2010) we proposed a way to make a one-year LTROP more powerful by targeting weakish sovereigns by accepting as collateral only non-AAA government bonds, which could be complemented by a "margin call holiday" protecting banks against further declines in the value of the collateral throughout the lifetime of the repo.

c) Move to the "shock and awe" approach, re-start SMP and purchase bonds on the secondary market.

Eoin Treacy's view Today's ECB policy meeting signalled that the ECB is still reluctant to become overly active in the Eurozone's sovereign debt markets. They have recommenced purchases in the secondary market but seem to have focused on Irish and Portuguese debt rather than Spanish and Italian. Talk of the potential for additional rate hikes is hardly what a cash strapped periphery wants to hear as spreads continues to widen.

Mr. Trichet's comment "I wouldn't be surprised that before the end of this teleconference you would see something on the market," suggests he thinks he can talk the market down. At this stage, bond market evidence suggests otherwise. The ECB will have to cease dabbling and commit considerable capital if they are serious about altering the upward trajectory of Spanish and Italian spreads.

During the financial crisis of 2008, the TED spread became a barometer of the perceived risk in the banking sector. The TED spread refers to the difference in yield between US 3-month LIBOR and US 3-month Treasury bills. It reflects the premium required to lend to banks over the US government. The spread proved a useful tool in 2008 but I suspect that the Eurozone's equivalent may be a better indicator on this occasion since the problems are primarily focused on that region.

The EUR Libor 3-month - EUR Generic 3-month spread broke out of a two-year base this week. While still at a low level compared to 2007 through to late 2008, this is an unfortunate development. The spread looks likely to head higher and that suggests this crisis is likely to get worse before it gets better.

The DJ EuroStoxx Banks Index continues to deteriorate. This table, of the index's constituents ranked by year-to-date return, illustrates the extent of the selling pressure. Not one has posted a positive return this year. The ECB signaled today that is willing to make liquidity available to the banking sector which indicates that it is still opposed to allowing a major Eurozone bankruptcy in the financial sector. However it looks increasingly likely that this commitment will be put to the test. (Also see Comment of the Day on June 16th).


AAA rated EUR corporate bonds are also reflecting the heightened sense of risk. The spread of the EUR AAA Composite over German Bunds has surged over the last few weeks to 130 basis points. A clear downward dynamic would be required to indicate renewed demand for this sector. However, AAA securities outside of the banking sector could become an attractive proposition when this crisis eventually reaches its nadir.