(MoneyWatch) The European Central Bank's effort to give Europe an August vacation from the financial crisis has been wildly successful. Spain and Italy's borrowing costs have plummeted in the weeks since Mario Draghi, the central bank's president, said he would do "whatever it takes" to save the euro - in a few weeks. Now the question is will the EU's leaders take action when they come back from vacation?
Just after the bond prices peaked at the end of July, Draghi said the ECB "may undertake outright open market operations of a size adequate to reach its objective" and that European Union officials should "stand ready" to also use their bailout fund in the bond market. He also said that any actions would take at least a couple of weeks to set up. Since then Spain and Italy - the biggest at-risk economies in Europe - have reaped the benefits of investors' belief that ECB action was imminent.
When the interest rate on 10 year bonds goes over 7 percent it is generally thought that nations can no longer afford the cost of borrowing money. On July 24 the interest rate for Spain and Italy's bonds were the highest they have been since the financial crisis began. That day saw Spain's 10- and 5-year bonds both at 7.6 percent. Today they are at 6.2 percent and 5 percent, respectively. For Italy the day saw its 10-year bonds at 6.6 percent and the 5-year at 6.3. Today they are at 5.6 percent and 4.6 percent.
If this rally is to continue, then investors are going to need to see the ECB actions which Draghi implied it would take. The markets have reacted very badly in the past when the central bank president did not follow through on actions which analysts had inferred from his comments. But it is not just Draghi's moves that will have an impact on Europe's economy.
German Chancellor Angela Merkel is under pressure from other EU leaders to soften the terms of the Greek bailout. Greece is essentially in a depression right now and the nation's leaders are seeking more time to implement budget cuts demanded by lenders in order to get the money keeping the government open for business. Last week Athens was forced to stop outlays of public funds for everything except salaries and pensions. If it doesn't continue to get that money, it is very possible it would have to leave the euro.
However, Merkel is also under pressure from German voters and politicians not to agree to any changes. An expansion of Greece's $215.35 billion bailout agreed to this spring faces adamant opposition in Germany's parliament. Partners in Merkel's governing coalition have said they would topple the government before allowing any such change. The chancellor is set to meet with French President Francois Hollande on Thursday and Greek Prime Minister Antonis Samaras on Friday. Aides to Merkel have said these meetings will be key in determining Berlin's actions.
Although the bond markets have stabilized in the last three weeks, Europe's economy has been hit with a lot of bad news:
- The eurozone edged closer towards its second recession in three years as the single currency bloc's GDP shrank 0.2 percent in the second quarter. This comes after a first quarter, which saw no growth. Six eurozone countries -- Greece, Spain, Italy, Cyprus, Portugal and Malta -- are already in recession and there are troubling signs in several other member states.
- Spain and Italy have both seen commercial real estate grind to a near complete halt. There were only three property transactions registered in Spain during the second quarter, down from 58 deals in the previous quarter. In Italy just two buildings were traded during the period, down from 56, according to data from Real Capital Analytics.
- Spain's banks, which are overwhelmingly dependent on the ECB for funding, saw their non-performing loans rise to a record 9.42 percent of outstanding portfolios in June, up from 8.95 percent in May. July's numbers will almost certainly be worse as house prices fell by 11.2 percent last month, the biggest monthly fall since March 2011. Prices have fallen by 31 percent since the financial crisis hit in 2008. Spain has an estimated two million unsold homes.
- The Spanish government will not hit its promised budget numbers this year. Economists believe overspending will remain close to 8.9 percent of GDP for a second year. In June the central government exceeded its limit for the whole year as it bailed out several regions, town halls and the welfare system amid the second recession since 2009.
Investors are hoping that Draghi and the ECB will begin buying the bonds of Spain and Italy again in September. That hope is what has kept the bond prices low. In addition to that, EU leaders may also have to show they have a workable plan for making Spain and Greece into functioning economies again. That is a tall order to fill in a very short time.