ECB policy tightening sends eurozone borrowing costs soaring
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Eurozone borrowing costs have surged to multiyear highs as the European Central Bank reins in its stimulus programmes, underscoring the challenge for policymakers in trying to cool inflation without upending bond markets.
Germany’s 10-year government bond yield — a benchmark for the eurozone’s debt markets — climbed above 1 per cent for the first time since 2015 on Tuesday, as investors braced themselves for the ECB to stop adding to its €4.9tn bond portfolio in the next few months, followed by a series of interest rate rises, starting as early as July.
Investors are also demanding a bigger premium in borrowing costs to lend to riskier, more indebted eurozone countries at a time when many are already facing increasing economic headwinds.
Italy’s 10-year yield spread versus Germany, considered a barometer of political and economic risks in the euro area, climbed as high as 1.9 percentage points on Tuesday, its widest since the early stages of the pandemic when investors dumped riskier eurozone government debt.
“What we are seeing in markets is the realisation that ECB tightening is at our door,” said Rohan Khanna, a fixed-income strategist at UBS. “It’s a double whammy for the most vulnerable sovereigns of increasing funding costs right when growth expectations are being downgraded. I think the market will try pushing Italian spreads through [2 percentage points] to really test what the ECB is going to do about it.”
Italy finds itself in the market’s crosshairs thanks to Rome’s vast debt load, which was driven to a record high of close to 160 per cent of gross domestic product last year by the economic fallout from the pandemic.
Frederik Ducrozet, a strategist at Pictet Wealth Management, said his “rule of thumb” during the eurozone debt crisis a decade ago was that the “danger zone” for the spread between 10-year bond yields of Italy and Germany was anything above 2.5 percentage points. But he said “this pain threshold might be higher today, say up to [3 percentage points] for spreads . . . because the prospects for nominal GDP growth are higher”.
Eurozone governments are expected to issue almost as much extra debt this year as last year, but the ECB is due to purchase far less of it. Ducrozet estimated the ECB would buy only 40 per cent of net eurozone government debt issuance this year, down from more than 120 per cent in the past two years. In Italy, net issuance of government debt is expected to be about €80bn this year, slightly lower than last year, and the ECB is expected to buy about 45 per cent of it, down from 140 per cent last year.
Some economists say this will be manageable thanks to a combination of economic growth, high inflation, low interest rates and more than €210bn of grants and cheap loans from the EU’s Next Generation recovery fund.
However, investors have been reassured by Italy’s relative political stability since Mario Draghi became prime minister in early 2021 and economists fear this could be disrupted by next year’s election if it leads to the departure of the 74-year-old former European Central Bank president.
Erik Nielsen, chief economics adviser at UniCredit, said: “In six months time, I bet the conversation will be all about the Italian election and what happens after Draghi.”
“I worry about Italy,” added Ludovic Subran, chief economist of Allianz, pointing out that Italy’s economy shrank 0.2 per cent in the first quarter compared with the previous quarter, and is likely to be hit harder than most of its peers by an EU embargo of Russian energy imports and China’s Covid lockdowns.
Italy has an average debt maturity of seven years and it can still refinance many longer-term bonds maturing this year at lower interest rates. But that could change if the recent rise in yields persisted, Ducrozet said.
Ducrozet added that markets were still pricing in “the implicit assumption” that the ECB would step in to cap spreads on the debt of economically-weaker eurozone countries if needed. The central bank has said it can be flexible in how it reinvests the proceeds of maturities among the bonds it owns to tackle any fragmentation in bond markets.
In addition, the ECB has said it could introduce a “new instrument” to support countries facing a sharp increase in borrowing costs as rates rise. But Luis de Guindos, its vice-president, said last week the governing council had “not discussed any new anti-fragmentation programme in detail”.
The fact that such discussions, however vague, are taking place indicates that the ECB is nervous about the impact of tighter monetary policy on spreads in the eurozone and particularly Italy.
However, it will be tough to design such an instrument without further blurring the line between monetary policy and the financing of government deficits, according to Robin Brooks, chief economist at the Institute of International Finance.
Instead, the sensitivity to sovereign spreads is likely to slow the central bank’s shift to tighter policy, making it highly unlikely that the ECB will deliver the 0.9 percentage points of rate rises priced by markets this year, he argues.
“ECB policy normalisation has always seemed to me to be a fanciful thing,” Brooks said. “How do you do it when you have these debt overhangs? The markets are saying that having debt-to-GDP of 150 per cent is a major issue. If they continue on this tightening path I think you will see Italian spreads widen further, perhaps in a disorderly way.”
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