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Bundesbank rains on Draghi's ambitions

FRANKFURT (MarketWatch) -- When it comes to the notion of the European Central Bank buying government bonds, no means no.

That appears to be the message from the powerful German Bundesbank. The central bank reiterated Wednesday, on the eve of the ECB's August policy meeting, that it thinks such practices are misguided, threaten the institution's independence and potentially overstep its narrow mandate of keeping inflation in check.

While the ECB has acted without the Bundesbank's blessing before, "it would be very difficult right now for Mario Draghi to do these things while presenting to the world a unity of purpose" among European policy makers, said Stephen J. Lewis, chief economist at Monument Securities in London.

As a result, strategists say investors are poised for disappointment a week after ECB President Mario Draghi put his own reputation on the line by declaring the institution ready to do "whatever it takes" within its mandate to preserve the euro, adding for good measure: "And believe me, it will be enough."

Draghi, speaking in London last Thursday, also emphasized that widening yield premiums between peripheral and core euro-zone government bonds were distorting the transmission of the central bank's monetary policy.

Market participants took that as a sign the ECB was ready at minimum to resume its dormant program of buying distressed European government bonds in an effort to bring down dangerously high Spanish and Italian borrowing costs.

Spain's 10-year government bond yield (10YR_ESP) fell sharply in the wake of Draghi's remarks. After pushing above 7.7% early last week, the yield remains more than a full percentage point lower, though still troublingly high at 6.69%

The premium demanded by investors to hold 10-year Spanish bonds over German bunds also narrowed sharply after pushing out beyond 6 full percentage points at remains at around 5.32 percentage points. Two-year Spanish yield (2YR_ESP) , which also topped out above 7% last week, now trade near 4.57%.

European equities, including beaten-down Spanish stocks, jumped in the wake of Draghi's remarks.

Many of those gains could be undone if Draghi disappoints on Thursday, analysts said.

"Given the aggressiveness of Draghi's rhetoric, anything short of an intervention announcement…will disappoint the market," wrote Richard McGuire, fixed-income strategist at Rabobank International.

The Bundesbank last Friday moved unsuccessfully to squelch growing market speculation the ECB would announce bold crisis-fighting measures, with a spokesman telling various news outlets that it continues to find the notion of bond-buying "problematic."

On the other hand, purchases of bonds by the region's rescue funds would be acceptable, the spokesman said. On Tuesday, an unnamed Bundesbank official provided a similar take to CNBC.

On Wednesday, the Bundesbank posted on its website an English translation of an interview conducted in June with Weidmann for the central bank's internal magazine.

In the interview, Weidmann said the ECB must remain aware of its independence and must respect and not exceed its own mandate, which is solely focused on maintaining price stability. He said policy makers might "overestimate" the ECB's powers.

Weidmann also dismissed notions the German central bank is just one among 17 equal national central banks within the Eurosystem.

"We are the largest and most important central bank in the Eurosystem and we have a greater say than many other central banks in the Eurosystem," he said. "This means that we have a different role. We are the central bank that is most active in the public debate on the future of monetary union."

ECB reactivation of the bond-buying program, over the Bundesbank's objections, would be more likely if the euro-zone rescue fund, the European Financial Stability Facility, were also tapped to buy bonds, economists said. But so far, Spain has refused to apply for support.

"Draghi may hint…that future bond purchases may be possible in conjunction with the [rescue funds]. But even then any ECB bond purchases will not be sufficient to change the dynamics in peripheral bond markets, just as they weren't last summer," said Tobias Blattner, euro area economist at Daiwa in London.

News reports had indicated Draghi was working to build up support for bolder proposals, including plans that would see the region's rescue fund buy bonds on the primary market, while the ECB would hit the secondary market.

A rate cut, and measures aimed directly at banks, such as easier collateral requirements and additional liquidity injections were also reportedly on the table.

Most economists, however, expect the central bank to leave its main lending rate unchanged at 0.75% for now.

But a new long-term refinancing operation, or LTRO, in which the central bank lends money to banks for extended periods at cheap, fixed rates, is "the very least market participants are looking for," Blattner said.

A pair of three-year LTROs in December and February were credited with easing tensions in bond markets as fears of a near-term, funding -related bank collapse eased and institutions used the money to buy peripheral government bonds.

Monument Securities's Lewis said Draghi can undertake other efforts as well, including purchases of covered bonds or easing the rules governing collateral banks can swap for loans from the ECB.

The end result, however, is likely to be disappointment for investors who have driven down Italian and Spanish government bond yields and rallied European equities on hopes Draghi will deliver a bold round of measures, he said.

Meanwhile, German government officials on Wednesday reiterated opposition to the idea of granting the region's permanent rescue fund, the European Stability Mechanism, a banking license. That would boost the 500 billion euro fund's firepower by allowing it to borrow from the ECB.