Christine Lagarde will struggle to do a Mario Draghi. Euro zone bond markets have stabilised since the European Central Bank president hinted at a new tool to help weaker governments. But they probably won’t stay that way, and any intervention may not work as well as her predecessor’s infamous 2012 gambit.
The ECB’s pledge to speed up plans for a tool to fight so-called fragmentation, the disparity in funding costs between stronger and weaker euro zone sovereigns, has already helped. The spread between Italy’s 10-year bonds and Germany’s has narrowed to less than 2% from as much as 2.5% in early June. Superficially, there’s a similarity to Draghi’s plan a decade ago to buy debt via a new programme, which saw spreads decline and the tool unused.
Currently, market conditions don’t look as hairy as 2012. Italy is currently funding at just under 4% over 10 years. Its bond yields are roughly in line with equivalent maturity corporate bonds with the same /BBB rating and its spread to Germany is lower than the 2013-2015 average, before the quantitative easing programme kicked off, according to Refinitiv data.
And even Italy’s debt maths may help Lagarde sit tight. Assume Rome’s GDP growth reverts over time to its forecast potential rate of 1.4%, and inflation falls to around 2%. To stop its 147% debt pile inflating further Italy would only need a primary surplus, the fiscal position before debt costs, of less than 1%. That’s not far off its 0.2% target for 2025.
However, the economic backdrop will get trickier. Whereas the ECB was loosening policy in 2012, it now has to hike rates to fight an inflation surge, even as the global economy sours. The risk is investors fret higher borrowing costs and sluggish growth will undermine sovereigns’ efforts to deleverage, or force them into politically unpalatable belt tightening. With an election next year and the Eurosceptic Brothers of Italy leading the polls, fiscal probity and reforms may go out the window. A rate surge to 5% and growth rate of just 1% would push Italy’s required surplus to well over 2%.
The ECB’s own position is also weaker. A pledge to buy bonds of struggling countries risks angering critics who worry about the central bank funding governments. And whereas Draghi’s 2012 tool required countries to seek a bailout Lagarde’s one may have softer conditionality, making large bond purchases more controversial. Given the challenges, Lagarde is unlikely to enjoy docile markets for long.
The extra yield, or spread, investors demand to hold Italian 10-year bonds over equivalent German ones has fallen over 40 basis points since June 14, the day before the European Central Bank agreed to speed up work on a new bond-buying programme.
Italy’s 10-year bonds yielded 3.65% at 0730 GMT on June 21, according to Tradeweb data, some 194 basis points more than similar maturity German Bunds.
The ECB convened an emergency meeting on June 15, pledging to accelerate the completion of the design of a new monetary policy tool designed to address so-called fragmentation, or the widening of bond yields between different euro zone countries.
Source: Reuters (Editing by George Hay and Streisand Neto)
