The ECB needs a bazooka to close bond spreads
With inflation in the bloc four times higher than the central bank’s target, the rise in European yields this year makes perfect sense and the sell-off in the debt market has been quite orderly. But the risks of fragmentation increase as the yield premiums of peripheral countries soar relative to Germany. When a 10-year bond loses a fifth of its value in six months, it’s usually a sign of distress on the part of the borrower. This is not happening to a struggling company, but to Italy, Europe’s third largest economy.
With Italy’s 10-year cost of borrowing now at 4%, its highest level since 2014 and quadrupling at the start of the year, questions are beginning to arise over the country’s debt sustainability. The spread with Germany climbed above 230 basis points, to a two-year high. The rise in Italian yields has been incessant this year, across all maturities.
It’s hard to say at what interest rate investors will begin to wonder if the nation will struggle to make its payments. But the memory of the euro zone debt crisis a decade ago, when Italy’s yield soared above 7% and the future of the whole common currency project seemed in peril, remains fresh in the minds of policy makers. And while the pandemic has increased debt-to-gross domestic product ratios across the bloc, Italy remains more indebted than the region as a whole.
Additionally, about a third of existing Italian government bond debt, worth more than 850 billion euros ($910 billion), comes due over the next four years, with nearly 290 billion interest and principal payments to be refinanced next year only. Clearly, this needs to be scaled up to affordable levels; Italy is currently paying a weighted average interest rate on its borrowings of around 2.5%, according to data compiled by Bloomberg.
Of course, the growth side of the debt-to-GDP ratio is a key part of the picture, and the more consensual post-pandemic approach across the European Union to government borrowing strains and the $800 billion Next Generation recovery fund. euros are important. tax game changers. A second iteration of the NextGen fund could emerge shortly if the eurozone economy threatens to slide into recession.
More immediately, the big monetary question is when the cavalry of the ECB will show up with an anti-fragmentation plan to defend peripheral countries’ borrowing costs, with Greek yields up ninefold last year and bonds Spanish and Portuguese also suffering. Investors spooked amid the triple halt to bond purchases, the imminent arrival of sustained hikes in official interest rates and the withdrawal of super cheap subsidies for commercial bank borrowing from the central bank . Chairman Christine Lagarde learned a hard lesson early in the pandemic that it pays to speak with caution when discussing bond spreads.
The ECB’s belated move to tackle inflation risks withdrawing many stimulus measures simultaneously, which could lead to a credit crunch if financial conditions tighten too quickly. As a document prepared by the Bruegel group for the European Parliament shows, discussions are naturally underway to prepare for the potential emergency measures underway. Sadly, there was little talk at last week’s ECB meeting about what might be introduced to stave off “the gentlemen of the spread”. Moreover, despite Lagarde’s repeated assertions about the reinvestment flexibility of quantitative easing, analysts at Bloomberg Economics believe the program could be easily overrun if Italian yields climb well above 4%.
During the euro debt crisis a decade ago, ECB President Mario Draghi gradually regained control by combining powerful rhetoric and the threat of a big stick in an ultimately unused program called Outright Monetary Transactions. This has been accompanied by a host of unacceptable restrictions for sovereign countries, which the pandemic QE program has deftly overcome. But that was then – different measures are now needed in the form of an anti-fragmentation debt support package to prevent the most financially vulnerable members of the euro from separating from their wealthier neighbours.
It may seem bizarre that the ECB announced the end of asset purchases last week to quickly create a new bond-buying vehicle. But needs must, and the Governing Council can be proactive in reassuring financial markets that it can raise rates and withdraw stimulus while putting in place a mechanism to limit the inevitable fallout on the bond market of its new enthusiasm for a stricter policy. Policy makers need to get creative in the months ahead; if they wave a bazooka convincingly enough, the rush of buyers for cheap Italian debt will do much of the work.
More from Bloomberg Opinion:
• The ECB is no longer an inflation-targeting central bank: Richard Cookson
• Central bankers don’t know how to fight inflation: Mark Gilbert
• Memo to Fed: Hurry up and walk so we can slow down: Daniel Moss
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.
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