Spanish, Italian Bond Yields Fall as Nowotny Signals Broader ESM

Spanish bond yields retreated from euro-era highs and Italian bond yields retreated from post-LTRO highs as Ewald Nowotny, member of the European Central Bank's (ECB's) governing council, said that the European Stability Mechanism (ESM) could receive a banking license. Such a move would allow the permanent bailout fund to borrow money from the ECB, which many think would then allow it to buy sovereign bonds and cap yields.

Spanish 10-year yields had risen to new euro-era highs of 7.75 percent ahead of the comments. However, Nowotny's words sent yields lower, even as he really said nothing that was already known. Mr. Nowotny said, on the topic of the ESM gaining a banking license, “I think there are pro arguements for this,” adding “there are also other arguements, but I would see this as an ongoing discussion.” Finally, he said he is ”not aware of specific discussions within the ECB at this point.”

The EUR/USD and peripheral bonds all rallied on the news, however the chances of such a move remain slim. The very same idea was discussed nearly one year ago, when European leaders agreed the second Greek bailout and also agreed to bring forward the start date of the ESM. However, many leaders, including Angela Merkel of Germany, rejected such a move.

Conservative politicians such as Merkel see using the ESM as a debt purchaser as a means of monetizing debt, which Germany does not want. Further, Germans and other conservative core nations do not want to be seen mutualizing debts, which in effect this would be. By replacing individual nations' debt with ESM debt, the stronger nations that are responsible for larger shares of the ESM's funding would effectively be buying weaker, peripheral nations debt. Also, allowing the ESM to borrow at the ECB exposes the ECB to losses on debt.

Those who have followed the European Debt Crisis since its onset have seen this story play out before: one single person hints that there are positives to an idea and markets rally, only to be disappointed when the rumor does not actually come to be fact. Wise traders would use this bounce in European assets to put on fresh shorts. As Boris Schlossberg, famous forex strategist, said on CNBC's Fast Money yesterday, he would be short the EUR/USD at 1.20, which is below the current price. Effectively, he is saying short the pair at any price.

Should the ESM be given a banking license, it does not directly mean that it would be able to borrow cheaply. The temporary bailout fund, the European Financial Stability Facility (EFSF) has attempted to issue debt but has seen lackluster demand at auctions and has since ceased issuance of new debt. Last night, Moody's placed the bailout fund's Aaa rating on negative watch, meaning that it could be downgraded in the coming months.