German verdict positive; ESM likely in 2 weeks: Rabobank

The German Constitutional Court on Wednesday allowed the country to ratify the eurozone's new rescue fund and budget pact, giving a go ahead for the European Stability Mechanism (ESM) to bail out the beleaguered countries of Europe. Markets took this as a positive sign and rallied quite a bit. Lyn Graham-Taylor, Fixed Income Strategist at Rabobank believes the verdict met expectations. Going forward, the ESM maybe operational within the next couple of weeks, he feels.

Here is the edited transcript of the interview on CNBC-TV18.

Q: This verdict comes as a big relief. Were you anticipating these conditionality and how restrictive do you think they are going to be once the European Stability Mechanism (ESM) does come into play and once it starts getting down to the business of rescuing beleaguered countries?

A: It came in at the higher end of the expectations where the market priced in relatively good results and we generally say the conditionality is fairly limited and so quite straight forward.

Q: The constitutional court has said that the German Parliament has a veto on any fund size expansion. Does those posses a big risk if tomorrow they do need to get the ESM to become a bigger size to be able to help countries like Spain and Italy?

A: The fact is Germany would be far from the only country. It may have to go back to the parliament to increase their contribution to the ESM. So its not any higher conditionality than the law of other euro zone countries would have.

Q: How far away are we from till the ESM becomes operational?

A: It could be signed relatively shortly, maybe in the next couple of weeks. It seems a question of just getting the paperwork together, getting it signed and some mechanical processes to get it up and running.

Q: What part does this play as part of the full solution because last week we got the ECB's new bond buying programme, the Outright Monetary Transactions (OMT), we now seem to have a go ahead on the ESM, do you think all the pieces are in place for Europe to strongly respond to the situation both in Spain and potentially even in Italy. I will get to the question whether those two countries will come to the bailout table or not but at least in terms of strength of response?

A: We are definitely making strong progress towards it. Obviously the OMT which is the ECB bond purchase facility, it is likely that it won’t be able to make purchases in the primary market. So the ESM will have a role to play, not only in the primary market but also for the longer dated tenure where the ECB programme looks likely to not go beyond maturity of three years. So that's a large step forward.

However, the other factor to remember is that the ECB programme still must be sterilized. That throws up various issues which needs to be investigated fully by the market to assume the effect that it will have. But, definitely there have been huge strides, positive strides forward. However, we are still not there and it is not the final solution quite yet.

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Q: But none of this will work if neither Spain nor Italy acknowledge the need for a full-fledged bailout or make their application, if I want to use the technical term because unless they do so the ECB has no way of putting its bond buying plan into action and we are back at maybe seeing pressure on the yields.

A: In order to force Spain ultimately into accepting a bailout, the market effectively may have to test the reserve of the ECB to buy and also Spain to enter such a bailout. We still think it's probably two-three weeks before Spain actually seeks that bailout.

There are some regional elections in Spain in mid-October. The Prime Minister might try and wait until after those have taken place before ultimately accepting the bailout. And the market might have to pressure Spain into doing it.

Q: When you say the market might have to pressure Spain, you are saying we could expect to see yields rise back to the 7% level over the next few weeks before Spain is forced to the bailout table in a sense?

A: Yes they might not have to get up to that sort of level but if there is a strong signal sent and we see around 100 bps increase or something in the shorter tenures and oversee less in the longer tenures, that would definitely focus on the minds of Spanish politicians and it is likely quicken the process if they accept the bailout. The important thing then is we will see the colour of the ECB money and exactly how this process works.

Q: So you are painting in a potential bailout request by Spain, let's say mid-October?

A: Yes many commentators have said that earlier. But from the political background we think it won't be an immediate process and that is still 2-3 weeks off. You have to remember that there is still no publicly available information on exactly what conditionality Spain or any eurozone member is seeking to benefit from these purchases. There is also no information on what conditionality they will have to accept and what the involvement of the IMF will be. There are a lot of details that are fairly unclear.
 
From that point of view, you can't necessarily blame the Spanish government for holding such a bailout when actually they don't know the conditionality associated with it. There is some bargaining there as well.

Q: But in case Spain does come through with a bailout request, let's say in the middle of October or even November, one would anticipate that markets would be less nervous about such a bailout request simply because now the action plan seems to be largely in place. What would the ESM do because now it seems to have gotten the go through to be activated and how would the ECB respond? Last year everybody was terribly nervous about what would happen if a country like Spain were to request a bailout, that nervousness would be far reduced right?

A: The nervousness would definitely be reduced but everybody will still want to see exactly what the ECB is prepared to do and exactly how this will work. Ultimately Spain and one of these countries will have to seek a bailout as part of the ultimate solution to test the ECB's resolve. Perhaps as part of that process it will also eventually see the ECB having to roll along the curve in terms of the maturities that it is prepared to purchase and depending on the exact mechanics whether they will have to eventually make unsterilized purchases or not.

Q: We have spend the last three years looking for some sort of lasting solution to this sovereign debt crisis in Europe and I am not for a moment saying we found the perfect solution and that things are going to get better overnight, but have we made substantial progress at least in the last few months with the kind of work that the ECB has done, the clearance for the ESM and all this talk about the European banking union, fiscal consolidation. We seem to have made substantial progress right?

A: Yes we definitely have made substantial progress, we are still have a journey to go on but, if you look at both the ECB which is showing its commitment to keep the eurozone together and where politicians have come from in terms of mutualization of liabilities. Even if it only to a limited extent, it is still a significant amount but, so far it is a huge change in attitudes over the last year I would say.