ECB to hold fire, resist pressure to head for exit

The European Central Bank will hold interest rates at a record low of 1% on Wednesday and resist German pressure to flag an exit from its crisis-fighting mode as the euro zone recovery looks increasingly fragile and concerns grow about Spain.

Germany's powerful Bundesbank has led a push by central bankers from the euro zone's core for the ECB to begin preparing an exit from crisis measures that have seen it loosen the rules for tapping ECB funding operations.

The ECB has pumped over 1 trillion euros into the financial system with twin 3-year funding operations, or LTROs, to head off a credit crunch that late last year risked exacerbating the euro zone crisis and jeopardising the currency project.

The German-led group of policymakers is concerned that the wave of cash risks stoking inflation pressures.

Euro zone inflation eased to 2.6% in March - above the ECB target of just below 2% and higher than expected - but the renewed worries about Spain mean the ECB cannot afford to signal a rate rise or an exit from the funding measures.

"I think the situation is far too fragile for the ECB to meddle in exit strategies at the moment, especially if you look at Spain," said Berenberg Bank's Christian Schulz, a former ECB economist.

" It's clear the downtrend in yields on sovereign bonds was triggered by the LTROs. If the ECB were to say 'well, actually now we're thinking about exiting this strategy', that would cause concern over whether these low interest rates are sustainable. That's why I think they'll be extremely cautious."

Returns on Spain's 10-year bonds fell to 4.65% in early February, after the first of the twin LTRO operations, but have since risen back to about 5.4%.

A rise in government bond buys by banks in Spain and Italy in February showed they were plying the "Sarkozy trade" - a term adopted by markets after the French president suggested governments urge banks flush with ECB cash to buy their bonds.

This trade helped push down yields on Spanish and Italian government bonds, but the renewed concerns about the public finances in Spain - the euro zone's fourth-largest economy - have sent them higher again.

At Wednesday's post-rate decision news conference, ECB President Mario Draghi will be grilled on how worried he is about the possibility of Spain having to request a bailout after the rise in its refinancing costs.

Spain announced deep cuts to its central government budget on Friday as it battles to convince European partners and debt markets it can rein in its budget deficit in the face of growing complaints from the public. The savings for this year are around 2.5% of gross domestic product (GDP).