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Markets aren’t convinced the European Central Bank can lift interest rates and keep the bond yields of the euro area’s most-indebted members in check at the same time.
Italy, one of the nations most vulnerable to rising borrowing costs, saw its 10-year debt post the biggest slide since the pandemic as ECB President Christine Lagarde outlined plans Thursday for a first rate hike in more than a decade.
The spread over German bonds, meanwhile, edged toward levels that last prompted the ECB to start buying sovereign debt in an effort to stabilize the currency bloc as Covid-19 swept across the continent in March 2020.
Investors worry about the lack of a credible plan to tackle so-called fragmentation -- unwarranted jumps in the borrowing costs of weaker euro-zone countries relative to economically stronger ones. Some say only a new tool, separate from previous bond-buying programs, can contain spreads.
“This is a ‘whatever-it-takes moment’ for Lagarde,” said Nicolas Forest, head of global fixed income at Candriam, an asset manager with 180 billion dollars under supervision. He was referring to a speech by former ECB President Mario Draghi, who pledged to guarantee the integrity of the euro-area at all costs as the sovereign debt crisis raged in 2012.
Forest is particularly cautious over Italian and Spanish debt given volatility and the likelihood of increased bond issuance from those countries. “The ECB will need to avoid a policy mistake,” he said.
Central banks around the world are facing a precarious balancing act as they seek to combat soaring prices without crashing business activity. But the situation in the euro area is unique, comprising 19 divergent economies whose fiscal policies aren’t aligned.
The fear is that, without a plan, excessive spread widening could divert the ECB from its inflation-fighting mission, forcing it to halt -- or even start to reverse -- its cycle of rate hikes.
What’s been allocated so far to address fragmentation -- reinvestments from maturing debt accumulated under the ECB’s pandemic asset-purchase program -- is widely deemed insufficient. Programs like Outright Monetary Transactions, created by Draghi during the last crisis, still exist, but are seen as too inflexible to be suitable now.
New Tool?
A new instrument is in the works -- as first reported by Bloomberg in April. But details remain scarce. Some strategists reckon spreads hitting about 250 basis points could prompt the ECB to step in, even if just by unveiling the tool.
We’re not at those levels yet. The Italian-German bond yield spread is 225 basis points -- far from the 500 basis-point gap seen back in the worst days of Europe’s sovereign-debt crisis.
But the uncertainty is denting the euro, which erased gains after Lagarde offered only vague reassurance that “if necessary in the future we can design, we can deploy the appropriate instrument.”
It’s not even clear if the Council agrees on the need to create a new tool, said Michael Michaelides, G-10 fixed income analyst at Carmignac, who sees markets testing peripheral spreads further. “There’s evidently no agreement.”
A question many are asking is: When will policy makers consider market moves to be driven by speculators rather than fundamentals? Sometimes, however, intervention may be unavoidable.
“The more hawkish members of the ECB don’t want to discuss a backstop as they want to put pressure on Italy to rein in its debt,” said Said Haidar, founder of hedge fund Haidar Capital Management, whose fund Bloomberg reported gained more than 10% in April. “But Italy’s too big to fail.”
He sees the ECB likely coming up with a backstop or face having to suspend its cycle of rate increases to safeguard Italy’s euro membership. That should allow officials to “maybe” raise rates to 2% by the end of 2023 from minus 0.5% now, he said.
Even so, investors acknowledge that the ECB’s communication and credibility are at least as important as the instrument it comes up with. They’ll be looking for clues on future plans when Vice President Luis De Guindos, Executive Board member Isabel Schnabel and Lagarde herself speak next week.
“When Draghi did whatever it takes, when the ECB finally stepped in and backstopped the periphery, they never actually bought a single bond under the program they announced,” Haidar said. “But it worked. It was like a magic trick.”
Next Week
- Traders await the Bank of England policy outcome on Thursday, which follows the Federal Reserve’s rate decision a day earlier
- A very large slate of scheduled speeches by European Central Bank policy makers including Governing Council member Robert Holzmann, ECB Vice President Luis De Guindos, ECB Executive Board member Isabel Schnabel may offer investors clues on the upcoming pace of monetary tightening
- Bond sales from Germany, France, Spain, Italy, Netherlands and Finland are expected to raise up to 35 billion euros ($36.8 billion), according to Commerzbank AG, which estimates will be the third-largest week this year.
©2022 Bloomberg L.P.
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