Weakest Links

There were some signs of stress on Monday as markets continued to process hawkish shifts from central banks and the read-through for the Fed’s reaction function from another perplexing US jobs report.

The most severe price action showed up in the periphery, where BTPs and Greek bonds widened out significantly to German debt.

10-year yields in Greece rose 23bps, to hit 2.50% for the first time since April of 2020 (figure on the left, below). That pushed the spread with Italy to the widest since the onset of the pandemic. Meanwhile, the selloff in Italian bonds pushed the BTP-bund spread to 19-month wides (figure on the right).

Just last week, Greek officials said the country planned to repay €7 billion in loans from the IMF and the EU early in order to cut the nation’s debt ratio and “send a signal to the markets that the Greek economy is strong and healthy.”

In December, when the ECB laid out plans to wind down its pandemic QE program (PEPP), the bank suggested that if spreads were to balloon to undesirably wide levels, PEPP reinvestments could be shifted to the periphery to tamp them down. Just days before the December policy meeting, FT reported that Greece was “planning an appeal for the country’s bonds to remain eligible for new ECB purchases after March,” when PEPP ends. ECB officials said they were “amenable to finding a way” to keep buying Greek bonds in 2022. And they did find a way. Again, through PEPP reinvestments. The December statement specifically addressed Greece as follows:

This could include purchasing bonds issued by the Hellenic Republic over and above rollovers of redemptions in order to avoid an interruption of purchases in that jurisdiction, which could impair the transmission of monetary policy to the Greek economy while it is still recovering from the fallout of the pandemic.

Absent the channeling of reinvestment flows, ECB support for Greek debt could fall away once net purchases under PEPP cease given the country isn’t APP eligible. “Greece is well funded for several years and the ECB made a point in its monetary policy statement of saying PEPP reinvestment would take care of fact the APP still doesn’t allow Greek government bond purchases, so today’s moves are likely one or two large and inelegant sellers in a thin market,” Bloomberg’s Marcus Ashworth said.

I’d reiterate a favorite talking point: Nowhere is it more apparent that asset prices are administered in the post-financial crisis world than in periphery EGBs. As I wrote in late 2020, it’s not as simple as saying, “Well, central banks should just ‘rip off the Band-Aid.'” Those Band-Aids don’t cover paper cuts — they cover bullet wounds. Rip them off, and some of these borrowers are going to bleed out on the pavement (figuratively, of course). There’s no telling what the market clearing price is for Italian and Greek debt after all these years.

Money markets pushed the issue on Monday, with bets on 27bps of ECB hikes through September and 53bps by December. That’s up from Friday, the day after Christine Lagarde’s hawkish pivot, which I suggested might mark an epochal shift. Specifically, I said Lagarde may have “opened the floodgates.” Monday’s action in the periphery underscored the risk.

Although UBS was keen to emphasize that investors “shouldn’t panic,” the bank summed up the crux of the issue in a note out late last week.  “With [the February] meeting having provided a strong signal to suggest the ECB will most likely pivot towards a hawkish policy stance at its March meeting, the key question facing investors over the coming months is whether or not there is too much complacency currently in EU spread valuations.”

They were talking about credit spreads, but the overarching question is the same: How much price discovery is the ECB willing to countenance in euro fixed income?