By Tom Fairless 

FRANKFURT--Sunday's Italian referendum comes at a critical juncture for the European Central Bank.

The eurozone's monetary authority is preparing for a major meeting on Thursday, where it will decide on the future of its EUR1.7 trillion ($1.8 trillion) bond-purchase program, due to expire in March.

The ECB's bond purchases have acted as a fire blanket for the 19-nation currency union during a year of political upsets, cushioning the economy and keeping government bond yields in check in the face of such unexpected political events as the Brexit vote in June and Donald Trump's election victory last month.

Surprise is less likely this time, since polls have given an edge to a possibly disruptive "no" outcome in Italy. But this vote is taking place within the eurozone's borders, at a sensitive time for the currency area's third-largest member. Italy's banks are struggling under a heavy burden of nonperforming loans and several of them urgently need to raise capital. Electoral evidence that the government is struggling to impose its will could scare away investors.

A "no" vote would therefore play into the ECB's policy discussions on Thursday, European officials and investors said, potentially heightening the perceived need to keep buying EUR80 billion a month of bonds, even as some policy makers press Mr. Draghi to send a clear signal on how and when the so-called quantitative-easing program will be wound down.

"The ECB might chew on the risk that a 'no' vote delays absolutely necessary repair work on Italy's banks," said Martin Lück, chief German investment strategist at BlackRock Inc. "It wants to make sure that doesn't happen."

To cope with any immediate market volatility following the referendum, the ECB could temporarily tilt its QE purchases toward more Italian government debt. Such action, which could be taken without a formal decision by the bank's policy makers, would lend support to the Italian bond market going into next year. The central bank has pledged in any case to front-load its bond purchases before the holidays.

The ECB's bond purchases, however, aren't designed to prop up individual countries, but to help meet the central bank's mandate of keeping inflation just below 2% across the 19-nation eurozone, by lowering borrowing rates to boost lending and growth.

Any appearance of a bailout for Italy could be political dynamite in countries such as Germany, where senior officials have been pressing the ECB to start winding down stimulus measures.

"The ECB cannot afford to systematically deviate from the rules of the bond-purchase program," said Jörg Krämer, chief economist at Commerzbank in Frankfurt. "That would create the impression that QE is the same as Outright Monetary Transactions," a controversial, potentially unlimited bond-buying program created by the ECB in 2012 but that hasn't been implemented.

Still, the ECB's mandate is broad. Anything that affects the bloc's EUR10 trillion economy, from an earthquake to an election, must be considered by the bank's policy makers to keep on course.

Mr. Lück said if bond spreads in the coming days were to rise in an extreme manner--an outcome he considers unlikely--"Mr. Draghi might hint at the existence of OMT" at his news conference on Thursday. To activate that program, Italy would first need to formally seek an EU bailout.

Even if the short-term market impact is limited, the Italian vote kicks off a crowded political calendar in Europe. Germany, France and the Netherlands will all hold major elections next year, with populists ascendant in each.

Investors are concerned that Italy's referendum "marks the start of a storm coming to land in Europe," said Alex Dryden, global market strategist at J.P. Morgan in London. "People are battening down the hatches ahead of that."

Write to Tom Fairless at tom.fairless@wsj.com

(END) Dow Jones Newswires

December 04, 2016 04:25 ET (09:25 GMT)