ECB emergency meeting pledges sovereign bond support

The European Central Bank’s governing council announced it would essentially support under-pressure eurozone sovereign bonds after holding an unscheduled meeting today (June 15).

It also said it would speed up work by the Eurosystem on a new financial mechanism aimed at reducing stresses on some countries’ bonds. Bond markets reacted positively, with the yield on Italian 10-year sovereign debt falling by 0.36 percentage points to 3.86% after the ECB’s announcement.

The governing council’s last scheduled meeting, six days ago, did not announce any action over the rising spread. The spread has continued to increase sharply since then, leading some informed observers to speak of a second eurozone debt crisis.

Today, the governing council said it would “apply flexibility in reinvesting redemptions coming due in the PEPP [pandemic emergency purchase programme] portfolio”. The council said it was acting “with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate”.

The ECB also said it would “mandate the relevant Eurosystem committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the governing council”.

It is not clear what form the proposed Eurosystem mechanism to prevent financial fragmentation will take. Five Italian economists have proposed creating a European Debt Agency. Under their proposal, eurozone countries would stop issuing individual sovereign bonds, which would essentially be replaced by debt issued by the agency.

Schnabel pledges action on bond crisis

ECB board member Isabel Schnabel made it plain that the central bank would take action on widening bond spreads in a speech the previous day. Schnabel’s speech was the clearest given by any ECB official on the bond spreads, and ECB president Christine Lagarde did not give a statement today. This contrasted with the eurozone bond crisis of 2011 and 2012, where then-president Mario Draghi took the lead.

“The vulnerability to such fragmentation risks will only disappear with fundamental changes to the euro area’s institutional architecture,” Schnabel said. “Therefore, monetary policy needs, at times, to respond to market developments that undermine the smooth transmission of monetary policy.”

She argued that the current rapid fall in some sovereign bond yields was unrelated to the issuing countries’ economic fundamentals. “Put simply, fragmentation reflects a sudden break in the relationship between sovereign yields and fundamentals, giving rise to non-linear and destabilising dynamics,” Schnabel said.

Continuing bond market fragmentation would put eurozone countries at risk of financial contagion, with the eurozone especially vulnerable to these risks, she said. “Investors can rebalance their funds across countries easily without taking on foreign exchange risks, which makes destabilising capital flows more likely.”

She said investors must realise that “monetary policy can and should respond to a disorderly repricing of risk premia that impairs the transmission of monetary policy and poses a threat to price stability”. She the ECB could use PEPP reinvestments for this purpose – the mechanism it adopted today.

In words that echoed Mario Draghi’s “whatever it takes” speech in 2012, Schnabel said the ECB would prevent a bond crisis. “There can be no doubt that, if and when needed, we can and will design and deploy new instruments to secure monetary policy transmission and hence our primary mandate of price stability,” she said.

Looming crisis

Eric Lonergan, a fund manager at M&G, wrote on June 12 that the eurozone’s second debt crisis had started. “The good news is that we have been here before, so we have learnt some lessons,” he wrote.

“The bad news,” he added, “is that the underlying challenge is far greater: Italy – the likely epicentre of this crisis – has a far higher debt to GDP ratio.” Official Italian figures estimate the country’s debt to GDP ratio reached 150.8% in 2021.

“At the moment, we are on course for a full scale run on eurozone sovereigns,” Lonergan said. He noted that the yield on 10-year Italian sovereign bonds had risen from 0.5% in September last year to nearly 4% on Friday [10 June]”.

Spreads between GDP-weighted eurozone sovereign bond yields, and the equivalent overnight indexed swap have also risen sharply.

“If these levels are sustained, the consequences for fiscal policy become untenable,” Lonergan said. Markets could fear that Italy would default on its debt, leading to a major economic crisis.

Another analyst, Tony Yates, said the crisis was being caused in large part by faults in eurozone countries’ energy policies. Yates, a former member of the Bank of England’s monetary policy committee, said that both Italy and Germany were particularly dependent on imports of Russian oil and gas.

Russian president Vladimir Putin has threatened to reduce energy exports to European countries in retaliation for their imposition of sanctions after Russia invaded Ukraine. This has put considerable pressure on Italian bonds, in large part due to market fears over Italy’s high debt levels and weak fiscal mechanisms.

“We are seeing how local poor energy policies (interacting with past poor fiscal and structural policies) have spillovers to the rest of the union,” Yates wrote on Twitter. He argued that the ECB was justified in taking action to prevent the Italian bond crisis from worsening.

“A significant chance of an Italian exit would generate a colossal shock to real activity across the EZ [eurozone] and it’s right to work hard to avoid it,” he wrote. If the ECB made its support dependent on major Italian structural reforms, it might provoke a backlash against any reform, he argued.

Past legal challenges

The ECB’s statement that its action is necessary to support its monetary policy mandate may come under challenge. Yates noted that the new policy “might be in contravention [of] German constitutional law”. Several German plaintiffs, including former Deutsche Bundesbank officials, have brought legal actions against previous ECB quantitative easing programmes, which went to the country’s highest court.

The ECB initiated the PEPP in March 2020, expanding the maximum value of bonds it can buy to €1,850 billion ($1,923 billion) in December that year.