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Europe takes aim at Spain, Italy borrowing costs

ReutersEuropean Council President Herman Van Rompuy at a news conference in Brussels.

FRANKFURT (MarketWatch) -- European leaders defied low expectations in a closely watched summit meeting, delivering a range of firefighting measures early Friday morning aimed at bringing down soaring borrowing costs for Italy and Spain and agreeing to establish a single supervisor for euro-zone banks.

After meeting for hours behind closed doors in Brussels, leaders agreed that once a bank supervisor is in place, Europe's permanent rescue fund -- the European Stability Mechanism -- will be able to directly recapitalize banks.

Spain's recently announced plan to support its banks had raised concerns that doing so would add to the Spanish government's debt pile.

"We affirm that it is imperative to break the vicious circle between banks and sovereigns," European Council President Herman Van Rompuy told reporters in the early hours of Friday morning. "We ask the Council to consider these proposals as a matter of urgency by the end of 2012."

Also, loans made to Spain by the ESM won't have senior status -- potentially reassuring other creditors.

Leaders also said they stood ready to use existing tools -- the temporary European Financial Stability Facility, or EFSF, and the ESM -- "in a flexible and efficient manner to stabilize markets" -- an indication the funds can be used to buy government debt in the secondary market to bring down borrowing costs.

The agreement came after Italian Prime Minister Mario Monti and Spanish Prime Minister Mariano Rajoy reportedly refused to sign off on a 120 billion euro ($149.1 billion) plan to support growth and jobs in Europe until winning the concession on bond buys.

Financial markets cheered. Spanish and Italian government bond yields fell sharply. The yield on the 10-year Spanish bond (10YR_ESP) , which had flirted with the psychologically important 7% level on Thursday and pressed above that level earlier this month, fell nearly half a percentage point to 6.43%, according to electronic trading platform Tradeweb.

The 10-year Italian yield (10YR_ITA) dropped a third of a percentage point to 5.86%. Moreover, German bund yields jumped as investors shunned the safe-haven.

The closely watched yield premium demanded by investors to hold Spanish bonds over 10-year bunds (10YR_GER) fell by 0.56 percentage point to 4.82 percentage points, while Italy's spread versus Germany narrowed 0.46 percentage point to 4.22 percentage points.

The euro (EURUSD) jumped more than 2 ½ cents versus the dollar and remained at $1.2686 in recent action versus $1.2429 in North American trade late Thursday.Pressure eases on Spanish bonds

Asian stocks powered higher and Europe rallied. Spain's IBEX 35 stock index (IBEX) soared 4.6%. Europe Markets

Analysts said the outcome marked a victory for Spain and Italy, while German Chancellor Angela Merkel gave ground on her earlier refusal to consider fresh short-term measures to stem the crisis.

"It seems that this summit has marked the point where the weaker countries are feeling that their situation is bad enough that brinkmanship is more attractive than it has been in the past," said James Reid, strategist at Deutsche Bank in London, in a note. "This is creating more tensions in Europe than there has been for some time but might help bring things to a head more."

Analysts warned that questions remain over the effectiveness of the measures, while emphasizing that they do little to address the root causes of the euro zone's long-running debt crisis.

"The EFSF is soon to be wound down and needs to raise its funds on the open market, while the ESM doesn't exist yet, though its biggest contributor Germany should ratify it today in the German parliament. The problem with that is the fund has a maximum capacity of €500 billion and that includes Spain's and Italy's contribution, so it could well run out of money quite quickly," said Michael Hewson, market strategist at CMC Markets.

The total package "stops short of new decisive measures that would definitively mark a turning point," wrote economists at Barclays.