European Central Bank fights to keep Euro safe

On one side is the European Central Bank, which is spending billions to prop up Europe’s weak-kneed bond markets and safeguard the common currency.

On the other side are hedge funds and big financial institutions that are betting against those same bonds and, by extension, against the central bank, that mighty symbol of Europe’s monetary union.

The war keeps escalating as traders position themselves for what some believe is inevitable: a default by Greece, Ireland or perhaps even Portugal.

The strains grew Tuesday, when European finance ministers made no pledge to increase the emergency fund that the European Union has put in place to help protect the euro. The head of the International Monetary Fund, meantime, urged Europe to take broader action to fend off speculators.

“The game now is one now of cat and mouse,” said Pimco chief executive Mohamed A El-Erian.

Since May, when the Greek debt crisis exploded, the European Central Bank has bought an estimated $69 billion of Greek and other government bonds. It has also indirectly injected hundreds of billions dollars into weak banking systems in Greece and Ireland. But the speculators keep coming back.

After the bond purchases fell to zero in October, the central bank waded back into the market aggressively last week, buying about $2 billion of debt securities, mostly Irish and Portuguese securities, traders said. The bank has yet to disclose the size and scope of the purchases late last week, when its intervention was the most intense.

While the bank appears to have backed off this week, traders are waiting for the official accounting of its latest purchases. The data are due Monday — and will provide some idea of just how aggressive the central bank has been.

Already, the central bank owns about 17 per cent of the combined debt of Greece, Ireland and Portugal, Goldman Sachs estimates. Yet in the bank’s mano a mano with the bond market, psychology could be more important than money. No single hedge fund, after all, can hope to outgun the central bank.

The bank also has the element of surprise. By emphasizing that the central bank is “permanently alert,” president Jean-Claude Trichet has raised the risk for speculators who might try to profit by selling short Greek, Portuguese or Irish bonds.

But the amount of intervention so far is far smaller than many investors and economists think is necessary to calm markets. These people assert that the central bank, its assurances aside, is concerned about taking on so many bonds of peripheral European countries — and being forced into what would be a de facto bailout of overextended government borrowers and the banks that bought their bonds.

And the markets continue to probe that discomfort. Pimco sold the vast majority of its holdings of Greek, Irish, Portuguese and Spanish government bonds late last year and early this year, although it continues to hold German bonds, considered Europe’s safest.
One of the main dealers in European government debt, JPMorgan Chase’s European rates strategy head Pavan Wadhwa said many clients had been eager to sell bonds of peripheral European nations to the central bank and would do more if the bank continued to buy, reflecting a belief that one or more countries were headed for insolvency.

“If the ECB wants to buy, I would still be recommending to sell into the demand,” he said. Wadhwa said in its latest operations the central bank had hoped investors would hold onto their bonds, encouraged by its presence in the markets. Instead, many had taken the opportunity to sell.

The chief investment officer of a large New York-based hedge fund, who spoke on the condition of anonymity because he was not authorized to comment publicly, said his fund and others had shorted Portuguese and Irish government bonds during the summer. They had done so by selling bonds in the cash market directly but mainly by buying protection against default in the market for credit-default swaps, a type of derivative.
“That trade was profitable,” this money manager said. But he said the fund had closed its position because the trade had no further to run — the market was now discounting a strong likelihood that Ireland would be forced to restructure its debt in four or five years. Even after the central bank’s intervention last week, speculators have been maintaining large positions in credit-default swaps on Spanish bonds and on the debt of Spanish banks.

Sophisticated market actor

Still, traders and analysts say the central bank is a sophisticated market actor. It conducts many trades via the Bundesbank and other national central banks, which in turn act through a circle of commercial dealer banks. Trichet is known to keep a data terminal on his desk and speak frequently with the bank’s 20 in-house bond traders. He also occasionally visits them on a lower floor of the bank’s headquarters.

For the central bank, the timing of the latest flare-up was, in a way, convenient. Bond trading typically tapers off at the end of the year as fund managers close out their positions. So trading was thin and the bank was able to move the market with relatively small sums, traders said.

“It may be that the ECB could have moved spreads a long way without buying that many bonds,” said London-based HSBC fixed income research global head Steven J Major. By placing a lot of orders with numerous banks, the central bank also created buzz in the market, which helped exaggerate the effect of its bond buying.

But according to many traders, the bank has so far not intervened in the markets for Spanish or Italian debt, which would be harder to influence because of their relatively large size.

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