Time and again over the past several years, I’ve suggested that absent the ECB backstop, it’s impossible to know where periphery European debt might trade.
Hardly a novel observation, I know. But with net asset purchases set to end on July 1, and rate hikes commencing thereafter, this discussion is finally topical — urgent, even — after languishing in the realm of theory since Mario Draghi’s “whatever it takes” pledge a decade ago.
We often bemoan the death of price discovery in the QE era. And, to be sure, such lamentations are often more literal than figurative. Iteration after iteration of ZIRP, NIRP and large-scale asset purchases forced investors out the risk curve and down the quality ladder, compressed risk premia and distorted entire asset classes beyond recognition. But even as distorted markets go, European fixed income was a special case. Nowhere was the legacy of monetary policy experimentation more evident than in European bonds, both sovereign and corporate.
That’s an anecdotal assessment, but I can cite plenty of evidence. At one point in 2019, for example, half of the euro IG corporate credit market yielded less than zero. In August of that year, at least 100 different issuers in the euro-denominated credit market had all of their corporate bonds yielding below zero. For those companies, debt had become an asset. “If having negative-yield debt outstanding becomes a source of income, will levered companies be considered more creditworthy?” Howard Marks wondered, a few months later. On the sovereign side, the story is all too familiar. All of the poster children for Europe’s debt crisis enjoyed rock-bottom — even negative — yields as the ECB backstop nullified the market’s pricing mechanism.
All of that changed in 2022. In April, when short-end German yields turned positive, all benchmark bonds in the euro area yielded more than zero for the first time in eight years. At its June meeting, wilting under the heat of record-high inflation, the ECB pre-committed to a series of rate hikes.
Now, something that looks suspiciously like price discovery has reasserted itself. Italian yields are up some 100bps in two weeks, for example, to the highest since early 2014 (figure below).
As the chart text suggests, one issue is a lack of specifics around the ECB’s planned mechanism for avoiding fragmentation.
The bank has been explicit about the possibility of using the “flexibility” built into its pandemic QE program (PEPP) to cap spreads. Although net purchases under the program ended earlier this year, principal payments from maturing assets are being reinvested through the end of 2024, and the bank can divert those investments to stressed locales if needed. But the market wants more than that. Thanks in part to media speculation about a new mechanism, traders want details, and Christine Lagarde’s allusion to the deployment of “new instruments” was deemed wholly insufficient. Hence the accelerated selloff in Italian debt last week.
One worry is that the situation could spiral so quickly that the ECB doesn’t have time to finalize the details on a new facility. It’s possible there’s not consensus on a framework or even on the utility of creating a new mechanism at all. Diverted PEPP principal proceeds won’t be enough to contain any serious bout of stress, and any sort of program that amounts to the resumption of net asset purchases (never mind halting rate hikes before they even begin) would run counter to the bank’s efforts to tighten policy, effectively forcing the ECB to choose between fighting inflation or fighting fragmentation. That’s an important consideration.
Italy’s yield spread to bunds is above 225bps, the widest since the initial pandemic shock and consistent with stressed levels seen during fraught political moments (figure below).
Of course, German yields are rising too. This isn’t an idiosyncratic story about Italy, or at least not any more so than it always is given fiscal realities. Rather, it’s a story about a challenging macro backdrop and a forced policy pivot.
Earlier this month, I posed a question:
Forgive me, but does anyone know what’s going to happen if the ECB, an institution which, prior the pandemic, was destined to join the Bank of Japan in deflationary purgatory, is suddenly compelled to hike rates out of negative territory in 50bps increments?
Then, I answered myself:
The answer is “no.” No one knows what the ripple effects of that might be, especially considering the famously distorted nature of the euro fixed income market, which will also need to cope with the cessation of net asset purchases.
By Friday afternoon, markets bet on 165bps in ECB hikes by year-end, twice the amount priced a month ago. In the June statement, the bank all but promised a 50bps increment in September barring a moderation in inflation by then.
There’s certainly something to be said for the idea that Lagarde’s reticence is tantamount to prudence. “Fragmentation guidance would’ve painted a target on BTPs,” Bloomberg’s Michael Read wrote Friday. “Vagueness is an asset a central bank uses to avoid verbal guidance becoming self-fulfilling [and] granularity about a fragmentation tool would’ve emboldened the market to test the ECB’s resolve.”
It’s also worth noting that Draghi, who never raised rates, is still in charge. Not of the ECB. But rather of Italy itself. Last week, at the annual ministerial meeting of the OECD, he said soaring inflation in the eurozone is “largely the result of a series of supply shocks.”
