European Central Bank announces efforts to end bond market turmoil

The European Central Bank said on Wednesday it would take further steps to guard against spiraling borrowing costs in some highly indebted European countries. The announcement came after an unexpected meeting of bank policymakers seeking to allay growing concerns in the bond market.

Borrowing costs across eurozone countries have diverged sharply in recent weeks, notably between Germany, Europe’s biggest economy, and Italy, in anticipation of an interest rate hike by the bank.

This widening gap, an example of market “fragmentation”, illustrates the delicate task facing European central bankers in the face of inflation and could harm the bank’s ability to manage monetary policy in the 19 countries that use the ‘euro. Christine Lagarde, president of the bank, said last week that policymakers would not “tolerate” fragmentation.

On Tuesday, Isabel Schnabel, a member of the bank’s board, described the fragmentation as “a sudden break” in the relationship between government borrowing costs and economic fundamentals.

Last week, the bank said it would consider using reinvestment of proceeds from maturing bonds in its €1.85 trillion ($1.9 trillion) pandemic-era bond purchase program. dollars) to avoid this fragmentation, by buying bonds that would help reduce government borrowing. costs.

On Wednesday, the bank confirmed that it would make these bond purchases with “flexibility”, a term used to describe the bank’s ability to direct purchases to different bond maturities and between countries to better support its policy objectives. monetary, such as the purchase of a large part of Italian debt. The bank said it would also “accelerate” the design of a new tool to combat market fragmentation, without giving further details.

“What they said today was in a way as expected, and in a way also the bare minimum because they didn’t provide any details about the anti-fragmentation tool,” Oliver Rakau said. , German chief economist at Oxford Economics.

The divergent spreads emerged when the central bank changed its policy to fight inflation, which at an annual rate of 8.1% is the highest level since the creation of the euro in 1999. In addition to the ending bond-buying programs that have large amounts of government debt, the bank also said it would raise interest rates in July for the first time in more than a decade. This decision will be followed by another, probably larger, rate hike in September.

As traders bet on the level to which the central bank will raise interest rates to contain inflation, concerns are growing over the impact of the rate hike on highly indebted countries. Italy, which has the second-highest public debt-to-GDP ratio in the euro zone, saw yields on its 10-year bonds climb above 4% this week for the first time since 2014. The spread, or spread, between its yield and that of Germany, considered the region’s benchmark, reached its highest level since the start of 2020, when the pandemic rocked bond markets.

“The pandemic has left lasting vulnerabilities in the eurozone economy that are indeed contributing to the uneven transmission of our monetary policy normalization across jurisdictions,” the bank said in a statement on Wednesday.

According to analysts at RBC Capital Markets, flexible reinvestments of maturing bond holdings will not be enough to contain the widening of spreads. They calculated that repayments from the pandemic-era bond program would amount to 200 billion euros over the next year. Even if a fifth of that sum were reinvested in Italian bonds, it would be far less than the purchases at the start of the pandemic, when the bank first used the flexibility.

The announcement of the flexible reinvestments and the new tool pushed down bond yields across the Eurozone. Italy’s 10-year yield fell to 3.82% from 4.17% the previous day. Its spread with the German yield has also narrowed.

Wednesday’s statement, specifically the decision to task central bank committees with completing the new tool, “could be enough to cap spreads at their current levels,” Rakau said. “But not to significantly reduce, for example, the spreads between Italian government bonds and Germany. For that, we need more clarity on the anti-fragmentation tool.

The European Central Bank faces a particular challenge as it determines monetary policy in a range of economies. On the one hand, it is tightening its monetary policy in the face of high “undesirable” inflation, but on the other hand, it is trying to ease the financing conditions of certain countries through bond purchases.

“It will take a few days to see how the markets digest this, let alone more details from the ECB,” Claus Vistesen, an economist at Pantheon Macroeconomics, wrote in a note to clients. “The presence of an anti-fragmentation tool means the ECB has more room to raise rates without spreads widening excessively.”

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