The European Central Bank intervened dramatically in bond markets on Monday, backing up a verbal pledge to support Spain and Italy with action in an attempt to avert a financial meltdown in the euro zone.
Significant ECB bond-buying -- the only practical result of a weekend of frantic G7 and G20 crisis diplomacy -- forced down Italian and Spanish borrowing costs in an initial reaction.
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But stock markets fell across the globe as investors rattled by a historic downgrade of the United States' credit rating piled out of shares and into safe haven assets such as gold and German bonds.
Traders said the ECB had bought some 700 million euros (995.7 million pounds) in Italian and Spanish debt by 3:30 a.m. EDT, after it agreed on Sunday to broaden its controversial bond-buying program for the first time to include the bloc's third- and fourth-biggest economies.
"We expect them to do billions today," said one trader.
Equity markets that had been in headlong retreat in Asia fell by some 2 percent across Europe -- with the notable exceptions of Milan and Madrid -- after a pledge by G20 finance chiefs and central bankers to take all necessary measures to support financial stability, growth and liquidity. European politicians voiced relief that the market turmoil was not worse.
British Deputy Prime Minister Nick Clegg said it was promising that statements from the French and German leaders, the ECB and finance ministers, had had "some effect at placating the markets and calming the markets" but governments had much to do restore their public finances.
The central bank action sought to change the dynamics on bond markets that had been pushing Italian and Spanish borrowing costs up toward unsustainable levels in the last two weeks.
"Speculators will now have to think twice about selling or shorting Italian and Spanish bonds, knowing the ECB will be acting against them," said Shane Oliver, head of investment strategy at AMP Capital Investors, one of Australia's biggest fund managers.
But experts warned the ECB would have to make large-scale purchases for a significant period to have a sustained impact, uncharted territory for the ECB and a move which was opposed by influential members of its Governing Council last week.
"The ECB will have to buy 320 billion euros of Italian and Spanish government bonds simply to maintain the same proportion of purchases made relative to the outstanding debt of Greece, Ireland and Portugal made through the 75 billion euro Securities Market Programme acquisitions to date," said Vincenzo Albano, Reuters Insider Fixed Income analyst.
Spreads of Italian and Spanish bonds over German debt narrowed sharply, the cost of insuring peripheral European debt against default fell and the euro initially rose against the dollar.
Investors also turned their attention to what the Federal Reserve might say at its policy meeting on Tuesday, fuelling speculation it might soon have to consider a third round of quantitative easing to resuscitate the world's richest economy.
COUNTING ON ECB, FED
After a rare Sunday night conference call, the ECB welcomed announcements by Italy and Spain of new deficit cutting measures and economic reforms as well as a Franco-German pledge that the euro zone's rescue fund will take responsibility for bond-buying once it is operational, probably in October.
"It is on the basis of the above assessments that the ECB will actively implement its Securities Markets Programme," ECB President Jean-Claude Trichet said in a statement.
The central bank had been reluctant to step up its buying of distressed debt, fearing it would be seen as a blank check to spendthrift governments.
Since the program began in May last year it has bought just 76 billion euros of bonds, while Italy and Spain alone issue around 600 billion a year.
Berlin denied that Germany and France had made any stronger promises about the euro zone rescue fund's (EFSF) commitment to purchase the bonds of weak member states in the secondary market, after the ECB singled out that pledge.
But the fact that German Chancellor Angela Merkel and French President Nicolas Sarkozy stressed on Sunday that the EFSF could soon buy bonds on the secondary market may have encouraged doubtful ECB policymakers to step into the breach in the interim.
They face a difficult balancing act.
"The trick is (for the ECB) to buy enough to show such a commitment to a certain yield level that investors feel comfortable in buying alongside the ECB," said Gary Jenkins, head of fixed income at Evolution Securities.
"That's a tough trick to pull off because if the market is not confident of ultimate full repayment then it will eventually just allow the authorities to fund and bail out as in the cases of Greece etc."
A bailout of Italy would overwhelm the EFSF's existing resources. Germany has so far opposed expanding it but French Finance Minister Francois Baroin said: "The allotment is 440 billion and we've already said if we need to go further we will go further."
The Group of Seven major industrial nations -- the United States, Britain, Canada, France, Germany, Italy and Japan -- said they would take joint action if needed in foreign exchange markets because "disorderly movements ... have adverse effects for economic and financial stability."
A G20 communique along similar lines followed shortly after European markets opened. The Japanese intervened to restrain their currency last week while the Swiss National Bank surprised with a new round of easing as it fought a rapidly rising franc.
Pressure is now growing on the Fed to try further easing -- dubbed QE3 by the market -- though few expect anything dramatic as early as Tuesday's policy meeting.
"We are probably a little bit closer. But I don't think we're there yet," said Nomura's chief global economist Paul Sheard. "I think the Fed would have to get a little bit more concerned that financial markets were spinning out of control before accepting with QE3."
CHINA NOT HAPPY
None of which was enough to reassure Washington's single biggest creditor, China.
"It must be understood that if the U.S., Europe and other advanced economies fail to shoulder their responsibilities and continue their incessant messing around over selfish interests, this will seriously impede stable development of the global economy," said a commentary in the People's Daily newspaper, the mouthpiece of China's ruling Communist party.
China holds well over a trillion dollars worth of U.S. government paper and was not pleased when Standard & Poor's cut the U.S. debt rating to AA-plus from AAA -- a move that also angered Treasury Secretary Timothy Geithner.
In an interview on NBC and CNBC, Geithner said the rating agency "has shown really terrible judgment" and claimed its downgrade wouldn't affect investors' faith in U.S. debt.
Japanese Finance Minister Yoshihiko Noda put a brave face on it on Monday, saying that market trust in the dollar and U.S. Treasuries has not wavered and indicated Tokyo's readiness to maintain its massive holdings of U.S. government bonds.