Spain's De Guindos, Germany's Schaeuble Reach Agreement on Bond Buying

Tuesday afternoon, reports from Madrid revealed that the ECB and other European authorities may in fact be closer to purchasing bonds in the open market than previously thought. Earlier, markets were discounting the reticence of key German economists in supporting bond market purchases. However, comments from the finance ministers may point to imminent bond market intervention.

The two finance ministers, De Guindos of Spain and Schaeuble of Germany, have apparently reached a consensus in which Spain will enact further budget reforms to appease the conservative Germans at the ECB and other institutions in Europe. Spain agreed to push cuts in health care spending and education spending to lessen deficits in an effort to appease Germany. This would be the latest round of spending cuts for Spain, a nation that is grappling with debt, banking and unemployment crises. ECB intervention may cap yields on Spanish bonds, decreasing funding costs and interest expense and shrinking deficits in the process.

Many types of intervention are being discussed by traders and investors. Some believe that the ECB could launch a full-scale quantitative easing program. This program might be unlikely though, given that it is against the ECB's charter. Alternatively, the ECB could launch another round of Longer-Term Refinancing Operations, allowing banks to take cheap funding and invest it in sovereign bonds to hold to maturity. This operation would effectively give the banks a risk-free carry trade. Also, the ECB could reactivate the Securities Markets Program (SMP), where it bought bonds in the open market in the past.

There are also non-traditional measures that the ECB could deploy. Rumors have been circulating that the ECB could purchase bonds using capital from the temporary bailout fund, the European Financial Stability Facility (EFSF). Also, some have been speculating that the fund could take an unprecedented step and declare a cap on bond yields of peripheral bonds. This would mean that the ECB would have to buy bonds in effectively unlimited quantities to keep yields down, not unlike that which the Swiss National Bank has done with its currency.

To hedge itself, the ECB could also consider another unprecedented step. The ECB could consider selling, potentially selling short, core bonds and putting a floor on yields. By increasing yields on safe bonds and decreasing the yields on peripheral debt, the ECB could narrow the spread and borrowing costs and restore some investor confidence into Spain and Italy.

Market watchers around the world await the specifics of just exactly how President Draghi plans to act. Historical policy actions from European leaders suggests that the response will not be the so-called “nuclear” action and would be a response that is just enough to prevent a collapse of the European banking system. Just like the numerous European summits that were deemed the "summit to end all summits," this meeting may be over-hyped, leaving open the chances of severe market disappointment. Surely, further clarity will come in the next few days ahead of the announcement Thursday at 7:30 am EST.