Francesco Canepa, Balazs Coranyi

FRANKFURT, (Reuters) – The European Central Bank has been struggling to persuade financial markets that it is committed to maintaining interest rates at rock bottom. However, it could win the argument if it stays true to its word and continues to follow through at its policy meeting next month.

Markets are pricing in a rate rise next year. They have also increased borrowing costs for huge debtors, such as Italy. These actions contradict the ECB promise of keeping credit open through a spike in inflation which it believes will diminish in 2022.

Christine Lagarde, President of the ECB, engaged in a stronger rearguard action Wednesday after failing to convince traders last week at her news conference. She stated that a rate increase next year is “very unlikely”

Lagarde said that Euro zone bond yields declined after Lagarde spoke. German 10-year yields were at their lowest point in just over a month. [GVD/EUR]

Piet P.H. stated that “the biggest difference from last week was the fact she provided a time reference for this time.” This should lead to market rates being lower. Christiansen, chief strategist at Danske Bank.

The Reserve Bank of Australia was forced to abandon its promise to hold the benchmark 2024 bond yield at zero this week by investors. Instead, they are pricing in a Bank of England rate increase on Thursday.

The ECB was the shoe they hoped would drop next.

However, the central bank in the 19-country Euro zone is still the one who controls its destiny. They have made any rate increase conditional on the inflation stabilising below 2%.

All the ECB has to do is update its December forecasts in order for inflation to fall below its 2% target. Reuters polled economists and found that inflation will be 1.6% by 2024.

Lagarde stated Wednesday in Lisbon that despite the inflation spike, inflation prospects over the medium-term remain subdued.

This message could be reinforced in December if ECB extended its Asset Purchase Programme to next year. It will provide support for eurozone government bonds even after expiration of the Pandemic Emergency Purchase Programme, expected in March.

Lagarde could find it difficult to convince the Governing council’s Hawks that inflation is getting worse.

It would still be the final nail in the coffin of bets on a rate increase next year. The ECB stated that it won’t raise the price of money before the APP is over.

Luigi Speranza, chief global economist at BNP Paribas (OTC) stated that “We don’t believe the sequence will change.”

ITALIAN JOB

The ECB may face the most difficult challenge in rescuing Italy from its debt crisis.

Spread between German and Italian bonds reached 130 basis points this week, its highest point in a whole year. This is a worrying development because the ECB tries hard to maintain easy financing conditions throughout the currency bloc.

Frederik ducrozet, Pictet strategist, stated that “the bigger problem” would be the persistent increase in BTP–Bund spread. Although the pain threshold might be greater than 200 basis point, it would still make it difficult to identify fragmentation if Italy is moving faster than Spain.

PEPP permits the ECB’s purchase of additional assets whenever it feels appropriate. With yields rising and spreads increasing, investors have been reminded that over the last two days.

The 1.85 trillion-euro PEPP will likely be retired by March. This leaves only the more flexible APP.

The APP is currently running at a very modest 20 million euros per month. This follows national quotas which are a critical condition to get approval from both the European Court of Justice (ECJ) and the German constitution court.

Francois Villeroy de Galhau, chief of the French central bank, has called for flexibility when spreading out purchases. Analysts expect that this will take form as an “envelope” of cash which can be used whenever needed.

Pictet’s Ducrozet stated that they will monitor the spread and can then address any questions with an additional APP envelope.

The hawks may find it easier to swallow, as they are cautious about taking on large-scale bond purchasing. A similar move did not calm markets in March 2020 and forced the ECB eventually to launch the more flexible PEPP.

As you can see, many experts and governors in more indebted countries of southern Europe are calling for some degree of flexibility to be transferred over to the APP.

“PEPP flexibility is proving valuable, so it would not be surprising to retain some of this flexibility in existing programs.” BNP’s Speranza said.