Market turbulence alerts the European Central Bank

Market turbulence alerts the European Central Bank
Written by insideindyhomes

As of: 06/15/2022 6:50 p.m

The European Central Bank (ECB) is resisting the sell-off of government bonds from southern euro countries. At an extraordinary council meeting, she decided on several measures.

How much interest can Europe take? The European currency watchdogs are racking their brains over this question. The interest rate hike announced in July has thrown the ECB into a dilemma. On the one hand, it must fight inflation, but on the other hand, it must not slow down the now sluggish economy in the euro area too much.

The turmoil in the bond markets now shows the fine line the central bank is walking. The currency watchdogs have been alarmed by the significant increase in yields on government bonds from southern European countries in recent days. Therefore, an extraordinary meeting of the Governing Council of the ECB was unexpectedly convened today.

Reinvestments should help indebted countries

At their special meeting, which lasted several hours, the currency watchdogs decided, among other things, to give euro countries with a higher level of debt a special helping hand in reinvesting the money from expiring bonds. In order to ensure that the tightening of the loose monetary policy that has just been decided does not put too much strain on these countries, funds from expiring bonds from the ended Corona emergency purchase program PEPP are to be reinvested. That could help countries like Italy, which now have to offer significantly higher interest rates for government bonds.

ECB working on new instrument

In addition, the central bank is working on a new instrument that is intended to curb the drifting apart of government bond yields. What the instrument should look like remained open. The media spoke of a “secret plan for Europe”. The monetary watchdogs fear that market participants would put the central bank to the test if they announce their countermeasures now.

According to the head of the Dutch central bank, Klaas Knot, the new instrument is intended to be used in the event that redirecting reinvestments towards bonds from southern euro countries is not enough. “We don’t know if that’s enough, it depends on the markets’ response,” said the Governing Council member. “But if that’s not enough, rest assured we’re ready,” he added.

Sell-off in the bond markets

The ECB announced a series of rate hikes at its most recent meeting last Thursday. It would be the first time in eleven years that the central bank has tightened its monetary policy. This caused a sell-off and falling prices in the bond markets; in turn, bond yields have soared.

The difference in yields – the so-called “spread” – between German government bonds and those of more heavily indebted southern euro countries, particularly Italy, is now at its highest level for over two years. While ten-year federal bonds are trading at around 1.7 percent, the yield on corresponding Spanish paper is around three percent. Ten-year Italian paper throw off around four percent, Greek even 4.6 percent.

Dilemma for the monetary authorities

Greece’s national debt is almost 200 percent of the country’s economic output, in Italy it is around 150 percent. In recent years, the central banks of the euro zone and the ECB have bought government bonds from the member countries on a large scale, thereby depressing long-term interest rates.

In the course of a tighter monetary policy, the ECB should actually part with the paper again – but that would probably weigh on the bond market even more. The central bank has already announced that it will stop buying new government bonds at the beginning of July.

In addition, Italian banks have invested in domestic government bonds on a large scale in recent years with cheap central bank money. The bond prices that have now fallen are threatening to weigh on the balance sheets of Italian financial institutions.

Bond yields fall slightly

The ECB’s announcement brought some calm to the bond markets. The yield on the ten-year Italian government bond fell to 3.92 percent. At the beginning of the week it had climbed to over four percent. The yield on Greek 10-year government bonds fell to 4.308 percent – down 0.35 percentage points.

The interest rate level in highly indebted countries such as Greece and Italy is therefore still well below the inflation rate in the euro area of ​​around eight percent. The devaluation of the currency helps the countries to deleverage. At the same time, it means a loss of assets for savers.

Experts had hoped for more

The important news is that the ECB wants to present something, commented interest rate strategist Antoine Bouvet from Bankhaus ING. “What matters is that something is coming and that at least gives potential sellers of Italian bonds the certainty that there is a limit to the widening of yield spreads.”

Jörg Krämer, chief economist at Commerzbank, was a little more skeptical. “The ECB reiterated today that it intends to use maturing bond reinvestments to support the bonds of heavily indebted countries like Italy. But obviously the ECB is not sure if that will be enough,” he said. In his estimation, a new aid program could dispense with reform requirements for the states concerned, but would probably provide for net bond purchases. This in turn brought new money into circulation, which would hamper the fight against very high inflation. The situation for Italian government bonds will remain difficult, Kramer believes. “It is now taking revenge that the country has been closing itself off to the necessary far-reaching reforms for years.”

“Whatever the ECB might do will be controversial,” Berenberg chief economist Holger Schmieding said It will probably result in further bond purchases, possibly in such a way that the ECB will partially replace bonds from some countries such as Germany with Italian bonds. “First of all, the ECB could replace expiring bonds from all countries with bonds from possible crisis countries such as Italy within its major pandemic crisis program PEPP,” explained Schmieding.

6:48 p.m

Euro cannot hold gains

On the currency markets, traders reacted to the ECB’s announcements with disappointment: the euro gave up its initial gains and fell below $1.04 again. In the morning, the common currency had risen by almost one cent to 1.0495 US dollars.

The ECB called its last extraordinary Council meeting in March 2020 – at the beginning of the corona pandemic. At that time, the central bank started its massive bond purchase program to protect countries like Italy from turbulence on the markets.

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