Markets brace for ECB guidance on debt crisis

Investors sought signs from central bank policymakers -- notably ECB head Jean-Claude Trichet -- on steps they were ready to take to tame a eurozone debt crisis now threatening Spain.

Many felt the ECB would maintain or boost support for banks and governments rather than continue to wind down exceptional measures as it had initially been expected to do.

Deutsche Bank economist Gilles Moec told AFP after the rate decision that he thought the bank would prolong unlimited loans of central bank cash into the first quarter of 2011.

In addition, Trichet might make "some positive sounds on the possibility to do more but nothing quantified, nothing concrete at this stage," Moec said.

At Capital Economics, Jonathan Loynes said any announcement on the ECB's controversial purchases of government bonds "is more likely to disappoint than provide encouragement that the ECB is about to come riding to the rescue."

Earlier this week, market rumours said the ECB would unveil a jump in public debt purchases, and it was widely expected to extend unlimited three-month loans of central bank cash into next year.

Some economists are now forecasting a possible extension back to six months.

But UniCredit fixed income strategist Luca Cazzulani said: "We expect no 'shock and awe' announcement" on bond purchases, following speculation the amount might leap to one trillion euros (1.32 trillion dollars) or more.

Growing belief the ECB would nonetheless signal more help for banks and governments helped ease market pressure on Spain on Wednesday, but Madrid was then forced to offer sharply higher yields on three-year bonds in an auction on Thursday.

That was a sign that fears persisted over its economy despite new government measures that included a partial privatisation of the state lottery company and the sale of a bigger stake in its airport operator.

Spain is the third biggest eurozone economy and a debt crisis there would represent a substantial worsening of a situation that has already sent shock waves around the globe.

"A lot of investors have progressively turned their attention over the past few days to the ECB as the potential actor that could put the fire out," Cazzulani told AFP.

Through a Securities Markets Programme that has divided the bank's governing council, the ECB has bought almost 70 billion euros worth of government bonds since May, a modest sum compared with moves by the US Federal Reserve and the Bank of England.

The eurozone sovereign debt market is worth about 5.5 trillion euros in all.

Some investors and economists felt the ECB should now go all out to keep a festering debt crisis from spreading to Spain and to Italy, the third biggest eurozone economy.

Such a move would present ECB policymakers with a major dilemma however, Cazzulani said.

"The problem with buying large amounts of debt is that it would become very difficult to sterilise them," he said, as the ECB does now by taking an equal amount in short-term deposits from commercial banks as an offset.

"If they don’t sterilise it it will be politically unacceptable for some EU countries" which fear inflation could take hold in the 16-nation bloc.

Buying government debt without offsetting the operations amounts to creating money and as money supplies increase so does the risk of inflation, which would raise hackles in eurozone heavyweight Germany.

The ECB is mandated moreover to keep eurozone inflation below but close to two percent, essentially the level it stood at in November.

At Morgan Stanley, economists said: "In the ECB's view, the next step-change towards a solution to the sovereign debt crisis has to come from governments. We agree."

Meanwhile, the ECB is also to present new staff forecasts for eurozone growth and inflation. In September it estimated 2010 growth in a range which had a midpoint of 1.6 percent, followed by 1.4 percent next year.

Inflation was tipped to come in at a midpoint of 1.6 percent this year before edging up to 1.7 percent in 2011.

The Eurostat statistics agency said Thursday that growth slowed sharply to 0.4 percent in the third quarter of 2010 from 1.0 percent in the second.

Last week, the European Commission warned that debt pressures had begun to threaten economic activity.