London (Reuters) -As the European Central Bank rushes to end stimulus and raise interest rates to control inflation, bond markets are testing its ability and willingness to act against the strains that are starting to hit weaker countries in the bloc.
Spreads, the extra amount investors want to pay for Italy, Spain, and Portugal bonds over safer German debt, have reached their highest level since 2020.
With ECB key rates expected to rise by 75 basis points in the next three months, the cost of borrowing money for 10 years in Italy and Spain has reached a level not seen in eight years.
So far, the ECB has said that it doesn’t think these weaker, highly indebted economies need any new tools to help them deal with higher interest rates. But as the spread has grown, investors have been wondering when and how the ECB might step in to stop so-called fragmentation risks.
The head of macroeconomic research at Pictet Wealth Management, Frederik Ducrozet, said, “There is no easy solution.” “We are here today because no decisions have been made in the last six months.”
Here are some things the ECB could do:
DO NOTHING.
With inflation at all-time highs, it seems like this is the current position.
The difference between the 10-year yields of Italy and Germany is 250 basis points, which was once seen as an ECB pain threshold.
But after last Thursday’s ECB meeting, sources told Reuters that policymakers did not think the current situation was “fragmentation,” and there was no talk about a new programme.
Rohan Khanna, a strategist at UBS, said that the fact that the subject wasn’t even brought up showed the market that the pain threshold is a lot farther away than we thought before.
2/BE AWARE
So far, the ECB’s only plan is to use money from bonds bought during the pandemic to help the economy’s return to markets that are having trouble.
But when spreads got bigger in April and May, it didn’t change the way reinvestments were made.
According to Societe Generale (OTC: SCGLY), the ECB will receive $314 billion from the redemption of its emergency PEPP scheme bonds over the next year.But I don’t think that has anything to do with spreading out.
Even if the ECB reinvests the entire flow of money from German and French bonds into Italy—around 12 billion euros per month—that will be less than the ECB’s net purchases of almost 14 billion euros per month in Italy since March 2020, SocGen said.
3/DO YOU REMEMBER SMP, OMT?
The ECB does have other tools at its disposal, such as the Outright Monetary Transactions (OMT) scheme, which is a crisis-time tool that has never been used and lets a country’s debt be bought as much as needed.
But economists don’t think it will be used because it requires countries to sign up for a bailout from the European Union, which often has conditions that people don’t like.
Others say it’s more likely that the Securities Markets Programme (SMP) will be brought back to life. This would let the ECB buy bonds without adding to the amount of stimulus already in the system.
4/ BRING BACK QE
If rapid spread widening makes the bloc’s finances less stable, the ECB could just start buying assets again. But since it just stopped buying bonds, that doesn’t seem likely.
Note, though, that on March 18, when the COVID-19 outbreak sent Italian and German bond spreads briefly above 300 bps, the Bank of Italy bought more bonds on behalf of the ECB.
Later that day, the ECB put its PEPP emergency plan into action, which calmed the markets.
“The obvious one would be (restarting) APP (Asset Purchase Programme),” said Timothy Graf, head of EMEA macro strategy at State Street (NYSE: STT). “But it’s hard to do when you’re raising rates,” he added.
5/A NEW THING
Maybe this is why people are talking more about a new tool that would let the ECB buy bonds only from the weaker states, instead of the usual rule of buying assets in proportion to the size of an economy.
But this kind of flexibility or going against the “capital key” could be a problem, especially with Germany’s constitutional court.
Andrew Mulliner, head of global aggregate strategies at Janus Henderson, said that the ECB “knows that whatever they do, it could end up in the German constitutional court.”