Dhara Ranasinghe & Sujata Ro

LONDON (Reuters), The European Central Bank might have raised the threshold that it can stop sell-offs of bonds in Italy or other countries within the euro bloc, which could be a result of record high inflation.

The shock at the ECB’s decision to renege on earlier promises not to increase rates in 2018 shocked markets across southern Europe, which is more debt-laden and poorer. Reacting to the news that its bond-buying programme — which is a lifeline in southern Europe’s financial crisis — might be canceled sooner than they expected, markets across Europe reacted with shock.

In comparison to their safer German counterparts, the yields on 10-year bonds issued by Portugal, Spain, Greece and Spain — all collectively known as the Euro Zone Periphery — was sharply increased due to the hawkish pivot.

Over the past week, the premium on Italy is up by 20 basis points. This country is arguably the most fragile due to the size of its debt.

Christine Lagarde (ECB President) has since appeared to be more relaxed about her stance. However, she isn’t denying fears that tighter policy will increase borrowing costs and worsen debt ratios which are among the highest in the world.

Graphic: Euro zone inflation at record highs- https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrjyrnpm/inflation1002.PNG

A lot of people ask where the ECB put’ might come in. This is a term used to explain the idea that the U.S. Federal Reserve will one day stop stock market declines.

In order to cap borrowing costs, the ECB purchased bonds of member countries since 2015. The periphery has been able to borrow less since March 2020 PEPP (its emergency stimulus program to deal with the coronavirus pandemic).

The yields of 10-year Italian Italian bond bonds, for example, were at their highest point just prior to the launch PEPP but dropped as low as 0.4% in one year.

JPMorgan (NYSE 🙂 called the ECB stimulus “a safety network for the perimeter”, without which the bond markets could fragment along national lines. Without this, the bonds markets would risk falling apart, dividing vulnerable and indebted people south of Germany and other wealther countries.

JPM forecast that “the market may test” Lagarde’s assurance after last week’s policy meeting, that the ECB will “obviously respond” to any spread-widening.

It brings back Lagarde’s comments early on in her role, that the ECB wasn’t there to provide “close spreads”, i.e. You will get a narrower yield premia.

Following the panic, the ECB announced PEPP.

Since then, inflation at the bloc level has reached a new record of 5.1%. This is after many years of failure to meet the ECB’s targets.

Gilles Moec, chief economist at AXA Group, stated that it was the first time in 2012 there has been a conflict between inflation or dealing with fragmentation.

INFLATION VS. SPREADS

Piet Haines Christiansen, chief strategist at Danske Bank, says that the ECB may be open to higher yields from the peripheral.

Haines Christiansen stated that “Back then, the pain threshold was lower. However, with inflation rising, Italy is becoming increasingly independent.”

“Previously, 250 bps on an Italian/German spread was my pain threshold for ECB. PEPP was announced at about 300 bps and I now believe it’s higher.”

Frederik Ducrozet, Pictet Wealth Management strategist, saw the danger zone for the Italy bond spread around 250bps — approximately 100 bps higher than current levels.

Graphic: Where is the ECB’s pain threshold on the BTP/Bund spread- https://fingfx.thomsonreuters.com/gfx/mkt/gkplgjkgnvb/BTP1002.PNG

David Riley, Chief Investment Strategist at BlueBay says that before the ECB puts can be reached, we would have to experience a spread of 200 bps.

However, Italy’s high debt-to GDP ratio is not a cause for concern. The country used low rates to increase its average maturity to seven years.

Haines Christiansen claimed that the only way to solve debt sustainability problems is for yields of Italy’s 7-year bonds to rise 150 basis points from their current level.

Jack Allen-Reynolds, Capital Economics Senior Europe Economist sees no reason to be concerned if the 10-year yields in Italy hit 5%.

CLEARANCE IS REQUIRED

A sell-off of sovereign bonds that leads to an increase in corporate borrowing costs will attract the attention policymakers.

They could not have responded to their question.

The ECB can control borrowing costs by focusing on where it reinvests its proceeds from matured PEPP bonds. It could also leave it open for bond purchases to be relaunched if necessary.

Analysts expressed hope that the ECB will provide clarity during its March meeting about what assistance would be given to the peripheral if spreads keep expanding.

BlueBay’s Riley believes that “we are far away from the ECB put” at present levels. Accordingly, despite higher yields from Italy, “in the short term, that’s no knife I’d look to catch”, Riley said.