Could the EU be facing another sovereign bond crisis?
Opinion editorial by Stuart Cole, head macro economist at Equiti Capital
- Unlike the Federal Reserve (Fed) and Bank of England (BoE), the European Central Bank (ECB) policy remains in ‘support’ mode
- But with CPI at 5%, tensions are growing that an accommodative monetary policy is no longer required
- The reality is the ECB is also working to avoid another blow-out in sovereign bond yields
European Central Bank becoming an outlier vis-à-vis its peers
- CPI forecast to fall back to 1.8% in 2023, below its 2% target rate
Current ECB policy has very much mirrored that of other major central banks, ie ultra-loose, intended to both boost inflation and support growth. Signs of a global return to monetary normalization are appearing. Notably, the Fed and the Bank of England have acknowledged the sustainability of current inflationary pressures and have begun tightening policy. But despite EU inflation rising to similar levels, the ECB’s position remains unchanged: inflationary pressures remain ‘transitory’ with CPI forecast to fall back to 1.8% in 2023, below its 2% target rate.
With ongoing global supply-chain issues, climbing energy prices and rising inflation expectations, the hawkish element of the ECB’s Governing Council has started questioning the Bank’s stance, arguing that an accommodative policy is no longer justified. But for the ECB, monetary policy implementation goes beyond just managing inflation: also included is the need to control bond yields. One result of the shifting stance at the Fed/BoE has been rising yields: for the ECB a similar increase is dangerous as it risks letting the ‘bond crisis genie’ out of the bottle again.
ECB balance sheet expansion has compressed yield spreads
Possibly the key factor behind the relative stability seen in euro-zone bond yields over recent years has been the ECB’s own buying. Two programmes are currently active: the Pandemic Emergency Purchase Programme (PEPP) launched March 2020 to counter risks to the euro-zone from Covid), and the Asset Purchase Programme (APP) launched January 2015 to prevent euro-zone inflation remaining low for a prolonged period. At their peak last year, combined purchases under both programmes totaled euros 100 billon per month. Although the PEPP ends this March, purchases under the APP will be temporarily increased to partially offset this closure, averaging euros 30 billion per month for the remainder of 2022. Despite CPI reaching 5%, the ECB is clearly signaling that its presence in the bond markets will continue.
But into this mix also needs to be added the ECB’s Targeted Long Term Repo Operations (TLTROs). Launched June 2014, these were designed to provide euro-zone banks with low-cost 3-year loans to encourage lending. Three operations were held. Lending under the first two operations has matured but some euros 2.2 trillion remains outstanding under the third operation. Although designed to boost lending to the real economy, it is likely that much of this finance was used to purchase euro-zone sovereign debt. Repayments are scheduled to begin in Q3 2022 and run every quarter until end-2024.
Taken together, these three schemes have expanded the ECB’s balance sheet to some euros 8.6 trillon. And herein lies its problem, namely that the removal of all this support – the PEPP, the TLTROs and potentially the APP – will see yields diverging once more, potentially to levels that threaten again the integrity of the euro-zone. The requirement to boost inflationary pressures has now passed, but with attempts at meaningful fiscal consolidation and economic reform in the weaker member states minimal, the ECB finds itself required to maintain its presence in the bond markets. It is for this reason that the APP has been assigned no end date and it remains to be seen if monthly purchases of euros 30 billion will be enough to keep bond prices buoyant.
ECB cannot afford another bond crisis
The already bloated ECB balance sheet means it will be desperate to avoid fighting another bond crisis. In practice this means it has become beholden to the euro-zone’s weaker member states. Italy is probably the biggest concern, given the size of its debt market. Not only are public finances still in a precarious position, but its banking sector is seen as heavily reliant on TLTRO funding. And with the relatively market-friendly prime minister, Mario Draghi, looking to leave his post, any signs the ECB is considering exiting the bond market could see Italian yields spike sharply, threatening a bond sell-off that could rapidly spread to other member states, with Spain, Portugal, Ireland, and Greece almost certain to be infected.
2022 could be the most difficult year yet
The need for highly accommodative monetary policy has probably now passed. But euro-zone sovereign debt dynamics remain challenging, and it is likely only ECB operations that are preventing a renewed episode of yield divergence. If the hawks on the Governing Council succeed in further scaling back ECB accommodation, then another euro-zone bond crisis looks possible, potentially threatening again both the euro-zone’s cohesion and the euro’s supposed inviolability. With the EU project already damaged by Brexit, facing rising anti-EU populism, and with sovereign balance sheets in a worse position than during the last crisis, 2022 may yet turn out to be the most difficult year the single currency, and all it entails, has yet faced.
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