The European Central Bank has plenty of ammunition left in its arsenal to fight trouble in the economy and banking system, although it has already fired its biggest gun at the government bond market.
Earlier this month, the ECB resorted to what traders described as its "nuclear option": buying sovereign bonds to help Greece and other weak European countries get through their debt crises.
The ECB also threw its gradual phasing out of emergency lending into reverse, resuming its offers of unlimited funds in three-month maturities, and it suspended minimum credit rating requirements for Greek government bonds used in its money market operations.
Overcoming its reluctance to follow other central banks into buying bonds was a big step for the ECB, and some in the markets worry that the central bank may have exhausted its supply of new weapons to take on the crisis.
"What's left? Not a lot, they've already crossed the last line," said ING economist Carsten Brzeski.
But the ECB still has plenty of ways in which it could expand its assistance to the money markets, and the reason it has not used them so far is probably that it thinks the crisis remains manageable with its current methods — not that it has run out of effective options.
Governing Council member Athanasios Orphanides made this case when questioned about the ECB's ability to act, saying it had unlimited scope for non-traditional measures.
"The room for conventional easing may be limited but the ammunition for unconventional policy easing is unlimited," he said last week. [ID:nLDE64K1G5]
LIQUIDITY
The failure of a small Spanish bank last weekend stirred concern that the euro zone's sovereign debt problems might trigger a broader financial crisis similar to the one in 2007-2008, when bank lending almost ground to a halt.
The two-year U.S. bond-swap spread <USD2YTS=RR>, a gauge of financial system stress, has risen to one-year highs and the equivalent euro swap spread <EURAB6E2Y=><EU2YT=RR> is at its highest level in 16 months.
But while spreads between the three-month euro London Interbank Offered Rate and overnight indexed swap prices — another key sign of financial system stress — have also widened, at 25 basis points they remain far below levels around 200 bps seen in October 2008.
The ECB may be waiting for any major worsening of indicators such as that one, or a more general freezing up of interbank money markets in the euro zone beyond the current borrowing difficulties experienced by commercial banks in a few countries, before deciding on further action.
One potential move is a cut in the ECB's refinancing rate, used to lend to commercial banks, which is now at a record low 1.0 percent. Since the rate is already so low, and markets are focused mainly on the ECB's 0.25 percent overnight deposit rate, analysts think a refi rate cut would likely have little impact.
Any benefit in easing pressure on banks' finances might be outweighed by the fact that markets could see a cut below 1.0 percent as a sign of panic.
But the ECB could expand its array of liquidity on offer by lending over longer maturities in both dollars and euros, and by maing dollar funds cheaper.
One option would be for it to reintroduce regular six- and 12-month euro refinancing operations in unlimited amounts, which were first used at the height of the global financial crisis.
"If the aim was to give lifelines to banks, then it could also return to unlimited tenders in not only three-month, but also six-month and 12-month LTROs," Brzeski said.
Extra long-term dollar operations might also help, despite low take-up at an 84-day dollar offer earlier this month, which was partly blamed on comparatively high interest rates. Banks paid 1.23 percent for seven-day dollar cash from the ECB on Wednesday, compared to a market rate of 0.33 percent. <USDLIBOR>
"It could decide to diminish the cost of the USD liquidity," Barclays economist Laurent Fransolet said.
"But we would note that it did not do so even at the worst of the crisis when the demand for USD funding was much higher and conditions were much worse than currently."
Another option would be for the ECB to stop reabsorbing the extra liquidity created by its government bond buying. Many analysts think this ending of sterilisation would not have much impact on money market conditions, since the ECB is already offering unlimited funds through other operations.
But the central bank, which had settled 26.5 billion euros worth of government bond purchases by the end of last week, could step up its government bond buying. This, combined with a possible easing of collateral rules for government bonds other than Greek ones, could push bond yields down further.
ING's Brzeski said the ECB might even consider the radical option of becoming an issuer of credit default swaps, used to insure against defaults, for sovereign debt. This would add liquidity to the thin, volatile CDS market and hurt speculators bidding against governments.
"If the aim was to calm down the bond markets, it could simply issue CDS on Greek debt," he said.
"Because the market is so small and so thin, you could simply flood the market with ECB CDS to take away the speculative element from the current CDS market."
CURRENCY INTERVENTION
Another option is currency intervention to prop up the euro, which has lost about 15 percent of its value against the U.S. dollar and about 12 percent against its trade-weighted index <EUREER=ECBF> this year, faster than the last and only time the ECB has intervened in the foreign exchange market.
In late 2000, the ECB moved to support the euro after it fell 11 percent in 10 months. But the euro was then at a record-low level; it is now close to its long-term average. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
For a graph on the euro exchange rate, click: http://graphics.thomsonreuters.com/0210/EZ_ERINTV0510.gif
For a factbox on ECB currency intervention, click: [ID:nL20669011] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
The ECB's rules say it can intervene in the foreign exchange market when it sees price stability in danger, but the ECB and private analysts alike see price movements as subdued.
Past ECB statements also speak against intervention. Executive Board member Lorenzo Bini Smaghi said in 2007 that intervention should go hand in hand with interest rate moves.
"Intervention is unlikely to have a lasting effect in the foreign exchange markets unless it is expected to be followed by domestic policy action, especially concerning interest rates," he said. Analysts do not expect the ECB to raise its interest rates this year. [ECB/INT]
And while intervention could calm financial markets, it might hurt economic growth in the euro zone, by slowing the currency depreciation which is boosting exports from the region.
Analysts therefore think the euro would have to fall further in a short period of time before ECB policy makers even started intervening verbally by threatening intervention.
"It would take a further rapid fall of the EUR below $1.10 and towards parity against the USD to arouse global concern," Unicredit's Marco Annunziata said in a note to investors.