Spanish, Italian Assistance to Come From Bailout Funds

More details have emerged on the latest steps to save the Eurozone and give aid to Spain and Italy. Following comments from the ECB President Mario Draghi Thursday, investors have renewed hope that leaders are Europe are stepping up to do whatever it may take to maintain the euro as it is.

Thursday, Draghi hinted that the ECB is preparing to do more to aid Spain and Italy. Friday, details are emerging that it would not be the ECB but the joint bailout funds that would be responsible for aiding sovereign debt markets. It seems likely that the European Financial Stability Facility (EFSF) and then the European Stability Mechanism (ESM) could buy sovereign bonds, not just in the secondary markets but also in the primary markets. This would be the first time either of these bailout funds bought bonds in the primary markets.

Buying bonds in the primary would be a large step for European leaders, for doing so would effectively be capping borrowing costs for peripheral nations. Yields on bonds only matter to the issuer when the time comes for them to issue new bonds. If the EFSF or the ESM bought bonds at auction, the extra demand could help to drive down borrowing costs, keeping nations such as Spain and Italy solvent.

The ECB could also step into the secondary markets to support nations where the fiscal situation continues to deteriorate. The central bank could reactivate the Securities Markets Program (SMP), where it bought bonds on the secondary markets to cap yields. An article from French newspaper Le Monde hints that the SMP could become reactive if a nation opts for a full sovereign bailout. In this case, the ECB would continue to act as one of the three arms of the Troika in supporting ailing nations.

The use of the EFSF and ESM to buy bonds is the first step towards a full fiscal union and joint liabilities. The bailout funds are funded by each EU member on a GDP-weighted basis. Also, the bailout funds issue debt, which is backed by the capital contributed by member nations. Therefore, these bonds are the first step towards Eurobonds. By buying sovereign bonds and issuing EFSF or ESM bonds, leaders are effectively replacing sovereign debt with European debt. This is a large step for conservative nations such as Germany, who have opposed Eurobonds, at least right now.

Germans seem to be ok with this new program. Finance Minister Wolfgang Schaeuble, who has been a large dissident when it comes to "more Europe," actually supported the plan to use the EFSF and the ESM to aid Spain and Italy, so long as they commit to reforms. He is against the ECB buying bonds however, because he stands by the ECB charter in which it says the central bank will not fund sovereign budgets.

Such a move by leaders might see a quick sympathy pop in the EUR/USD however would most likely see a sell-off later on. Any move by the ECB would most likely not be balance sheet neutral and would thus cause a devaluation of the euro against the dollar. Gold would also most likely pop on any hints of further central bank easing. Watch the ECB meeting next Wednesday for further color on the subject.