Today’s CIO Weekly Perspectives comes from guest contributors Patrick Barbe and Ugo Lancioni.
We’re used to hearing about the difficult job the U.S. Federal Reserve faces over the coming months. It wants to get on top of consumer price inflation of 8.6% without causing a recession or excessive job losses.
So, spare a thought for the European Central Bank. It would also like to achieve those two objectives, from a starting point of negative policy rates and inflation also running at 8.6%. But it also has a third variable to balance: the credit spread between German and southern European government bonds, which revives uncomfortable memories of the eurozone’s existential crisis a decade ago.
The ECB is expected to announce the details of an “anti-fragmentation” tool to help solve this trilemma on July 21. What will it look like? Will it be enough? And has the market already discounted for it?
Europe has an inflation problem. The war in Ukraine placed it at the global epicenter of rising prices. While there was some relief that the EU-harmonized measure of inflation for Germany came in below expectations last week, at 8.2% rather than 8.8%, inflation in Spain was much worse than expected, at 10%. Friday’s 8.6% figure for the eurozone as a whole was above expectations.
The weakness of the euro against the dollar isn’t helping. The currency is down more than 8% this year, adding to the rising cost of energy imports. If the Fed has been caught behind the inflation curve, that is an indication of how much further behind the ECB is, in the view of the markets. The euro has been falling even though rates markets are pricing for more ECB hikes than Fed hikes over the next three years.
No wonder ECB President Christine Lagarde is sounding increasingly hawkish.
The problem is that hawkish messaging doesn’t raise only Germany’s bond yields (which are up by more than 155 basis points this year); it sends southern European yields up even faster. The closely watched Italian 10-year yield is up by 212 basis points.
When the ECB announced on June 9 that it would end its quantitative easing program and begin raising policy rates, the spread between German and Italian 10-year yields spiked rapidly, to 240 basis points. Many investors see 250 basis points as a key level that could signal a perilous return to the euro break-up speculation of the past.
The first chain in the link between ECB tightening and Italian spreads is that ECB hawkishness leads to tightening conditions in credit markets as they start to discount the impact on growth. The next chain is that investors often see short-selling southern European bonds as a way to hedge portfolio beta to risky assets or credit.
This is happening despite what we view as Italy’s relatively strong fundamental outlook: It looks set to outperform in terms of its deficit, for example, due to the amount that some core European countries are spending to shield their consumers from inflation.
In response, the ECB is working on an anti-fragmentation tool to manage southern European spreads, thereby liberating itself to pursue its price-stability mandate unencumbered. The announcement was enough to take more than 50 basis points off the German-Italian spread, returning it to mid-May levels.
Can the new tool justify the market’s newfound confidence? In our view, there are three questions to be addressed.
Could bond purchases under the new tool come with limits or conditionality? It’s difficult to see how a limited program would achieve this aim—it would just be an invitation for the market to test it. And conditionality could dissuade potential beneficiary countries from accepting the purchases.
Could bond purchases be targeted at specific countries? In the past, bond purchases were allocated based on the Eurosystem’s capital key: The more capital national central banks had with the ECB, the more of that country’s bonds would be purchased.
That meant help was not targeted at the countries that needed it most, and the problem would be exacerbated today: The ECB does not want to push core eurozone yields down and worsen inflationary pressures. For that reason, we think the ECB needs to target specific countries with its new tool. We also think it likely that these purchases will be sterilized to avoid distorting monetary policy.
Will bond purchases aim for a specific, “fundamental” level of spread? We don’t think the ECB sees that as its job. Rather, we think the tool will aim to remove some of the speculative volatility in spreads by persuading the market that short-selling southern eurozone bonds is no longer an effective risk-off hedge. If it succeeds, we think spreads can gravitate back to the market’s view on fundamentals.
Throw in the Towel
In summary, we anticipate a tool that combines the speed and lack of conditionality of Outright Monetary Transactions with the power of the Securities Markets Program to make purchases across bond curves, but with a different aim from either: to take speculation out of eurozone spreads and return them to fundamentals.
Can the market be convinced?
We think the conditions are more conducive now than a decade ago. The war in Ukraine has strengthened European solidarity. There is goodwill toward Mario Draghi, the current prime minister of Italy and celebrated former ECB president. Perhaps most importantly, we believe Germany, the center of skepticism during the last crisis, has a clear need for a solution due to its struggle with energy price inflation.
That said, despite the spread retracement following the announcement of work on the anti-fragmentation tool, we do not believe its potential impact is fully discounted. We have seen some of the more speculative money throw in the towel, but investors with longer-term horizons appear to be waiting for the details before they move.
All risky assets remain vulnerable to recession and generalized negative sentiment—including Italian government bonds. Nonetheless, we think the new anti-fragmentation tool could give Italy’s spread potential to narrow from here.
In Case You Missed It
- U.S. Durable Goods Orders: +0.7% month-over-month in May (excluding transportation, durable goods orders, also +0.7%)
- S&P/Case-Shiller Home Price Index: April home prices increased 2.3% month-over-month and increased 21.2% year-over-year (NSA); 1.8% month-over-month (SA).
- U.S. Consumer Confidence: -4.5 to 98.7 in June
- U.S. 1Q 2022 GDP (Final): -1.6% annualized rate
- U.S. Personal Income and Outlays: Personal spending increased 0.2%, income increased 0.5%, and the savings rate increased to 5.4% in May, month-over-month
- China Manufacturing Purchasing Managers’ Index: +3.6 to 51.7 in June
- Eurozone Consumer Price Index: +8.6% year-over-year in June
- U.S. ISM Manufacturing Index: -3.1 to 53 in June
What to Watch For
- Monday, July 4:
- Eurozone Producer Price Index
- Tuesday, July 5:
- FOMC Minutes
- Friday, July 8:
- U.S. Employment Report
Investment Strategy Group