In recent years it has sometimes been thought that the area of responsibility of European Central Bank (ECB) concentrates on one thing: easy money. Ironically, it is now precisely the lobby of hardline supporters who must adopt liquidity.
A week of bond market reversals highlights the challenge of raising interest rates without causing big debt sales among weaker eurozone countries. Last week, the ECB stressed that it would address this by resiliently investing in its bond portfolio, but such a move is not even approaching To the necessary firepower. The governors were forced to convene an emergency meeting on Wednesday.
The ECB “will accelerate the completion of the design of a new anti-fragmentation instrument to be tested,” the bank said after the meeting. This is some step, but not exactly an excited call to action.
The largest gap since 2020 between Italian and German bonds
Indeed, investors still seem to believe that the risk of fragmentation in the eurozone will affect the central bank’s policy tightening plans. The euro, which initially rose, erased this rise after Wednesday’s announcement. Ten-year Italian bonds are trading 2.2% above German, the largest gap since the start of the corona crisis in 2020. The country is expected to pay a yield of 4% on a new debt, for the first time since 2014.
The situation is not as bad as in the euro crisis, so investors have been betting that the bloc of countries using the currency will fall apart. Today, it is the expectation of higher interest rates that is causing big sell-offs in all government bonds. It is only natural that Southern Europe’s debt – which is more volatile and less liquid – will be disproportionately affected by this. Relatively calm.
And yet, Italy has become an existential threat to the euro in an environment where borrowing costs are rising. If yields remain at today’s level, the country’s interest payments will increase after three years at a level that is about 1.5% of GDP, or between 25 billion euros (about 26 billion dollars) and 30 billion euros, according to the bank estimates for Bank-Yunus , An analyst at Scope Ratings. This will bring total debt service costs close to the level they were at during the euro crisis.
However, this should not happen. Any debt crisis in the eurozone will be the responsibility of the ECB itself.
“Fragmentation in the bond market knows no bounds”
On Tuesday, Governor Isabel Schnabel said the ECB’s commitment to combating fragmentation in the bond market “knows no bounds” but reiterated that the gaps between Italy and Spain’s bonds need to be wide enough to reflect the basic likelihood that these countries will go bankrupt. This is a fiction: the Federal Reserve makes sure that the risk of insolvency is not priced in the finance market at any level of interest, and so does the European Bank. If Italy is guaranteed constant liquidity to refinance its debt, does paying higher interest rates bring it closer to insolvency? No. Conversely, insolvency in Italy could put an end to the very existence of the ECB.
The hawks in the eurozone rightly see the fight against fragmentation as an explicit reference to the reciprocity between the debts of different countries. But this point is needless to say: whether it was a right move at the time or not, these countries have agreed to use the same currency. This means that monetary policy can only be implemented effectively if the target for bond spreads or gaps is zero – or at least a number close to that. When interest rates start to rise in July.
If austerity policies are to last in the eurozone, countries dealing with cross-border debt reciprocity will have to be more lenient than ever.