ECB Panics Four Business Days After Confirming Policy Pivot

The ECB has seen enough. Already.

Just four business days after confirming the imminent onset of a tightening cycle, the Governing Council called an emergency meeting, an apparent nod to the purported urgency of addressing fragmentation risk, as manifested in more than 40bps of widening in the spread between Italian and German bond yields over just a handful of sessions.

Italian bonds came under immense pressure in the aftermath of last week’s policy meeting and press conference, at which Christine Lagarde was vague about the bank’s plans to keep a lid on periphery yields during what promises to be a fraught push to normalize policy in the face of record high inflation.

Read more: Euro Fragmentation Demons Haunt ECB’s Rate Hike Dreams

The ECB discussed market conditions and sought to communicate more explicitly about its plans to address any undue stress.

“The pandemic has left lasting vulnerabilities in the euro area economy which are indeed contributing to the uneven transmission of the normalization of our monetary policy across jurisdictions,” a statement released following the meeting, which ran long, said, adding that,

Based on this assessment, the Governing Council decided that it will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate. In addition, the Governing Council decided to mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council.

According to media reports, policymakers last week decided it was best to remain vague about the specifics of any new facility aimed at capping spreads. The idea is that revealing the details of such a tool would prompt the market to test the bank’s mettle, knowing the ECB is constrained in its capacity to respond by the necessity of fighting inflation. I discussed all of this at length in the linked article (above).

Principal payments from assets purchased under the bank’s pandemic QE program can be reinvested “flexibly” to address stress in the periphery, where that just means reinvested proceeds can be diverted across locales (“jurisdictions”) as needed. The ECB has committed to reinvesting principal payments from bonds purchased under the program until at least the end of 2024.

But the market wants more. Generally speaking, those principal payments aren’t likely to be sufficient to contain any kind of serious episode. The market knows that, hence the relentless pressure on BTPs. Yields on the country’s 10-year debt rose above 4% this week (figure below) in an unrelenting selloff, exacerbated by rates volatility in the US.

Yields were still some 60bps above levels seen prior to the June policy meeting even after falling precipitously Wednesday on hopes that policymakers would calm markets.

Wells Fargo now sees the euro falling to parity with the dollar within a month as the Fed presses ahead with outsized rate hike increments, and the US economy outperforms the euro area. “The return of USD strength has come sooner than we had expected,” the bank’s Erik Nelson wrote. “In our view, the question of parity is more of a ‘when’ rather than an ‘if.'”

Fragmentation risk doesn’t help the euro, but neither, necessarily, would efforts aimed at warding it off to the extent such efforts involve more easing. That would only exacerbate the transatlantic policy divergence.

Both Italian and German bonds fell a fifth day on Tuesday, amid aggressive money market wagers on ECB hikes. 250bps on the spread at the 10-year point is an unofficial red line, and we were essentially there prior to the ECB’s Wednesday ad hoc gathering (figure below).

Frankly, it’s not obvious this warranted a response. Italy’s fundamentals aren’t comparable to Germany’s, and with German yields rising inexorably, it’s hardly surprising that periphery yields are rising more. Spain and Portugal saw their own yield spread to bunds tighten on news of the meeting.

The ECB on Wednesday put itself in the awkward position of having to come up with something above and beyond the statement language (e.g., something more than a renewed commitment to reinvesting principal payments from the pandemic QE program in periphery debt if needed), or risk exacerbating the very situation they met to address — an “own goal,” as it were. Whether the short statement suffices to calm frayed nerves remains to be seen.

The bank’s options are limited. Apparently, the ECB could front-load reinvestment flows or — I don’t know — use harsh language in an effort to dissuade the market. But any sort of move which amounts to the resumption of net asset purchases would run counter to the bank’s efforts to tighten policy, effectively forcing the ECB to choose between fighting inflation or fighting fragmentation. Any new facility could face legal challenges as well, even as the “fragmentation” cover story is a good shield. There’s no indication that such a facility is anywhere near being finalized. Wednesday’s statement suggested work on the new tool will be prioritized and hastened.

Isabel Schnabel made it very clear last week that “changes in financing conditions” deemed by the ECB to be inconsistent with “fundamental factors” or which “threaten monetary-policy transmission,” will be met with a “no limits” response. Schnabel is responsible for market operations — she’s the gunner.

Prior to the emergency meeting on Wednesday, Pierre Wunsch emphasized that the next 150-200bps of rate hikes are “no brainers,” but said the bank is “very open” to intervening if the market “overreacts.”