By Dhara Ranasinghe

LONDON, (Reuters) – As the European Central Bank race towards the stimulus exit in order to tame record inflation, angst regarding whether it is able to contain stress within weaker economies creeps back into bond markets corners.

Certain indicators of stress have fallen to levels not seen during the peak of the 2020 COVID-19 crises and are nowhere near the level of the 2011-2012 debt crisis in the eurozone. After the Ukraine pandemic, the cohesion has strengthened. France’s pro-European president was re-elected last month with an 800 billion-euro recovery fund supporting the bloc.

However, inflation is at 7.5% and the ECB will stop buying bonds soon. This could challenge weaker Southern European countries as well as bring fragmentation risks back to focus. As their government borrowing costs go up, they are more expensive than Germany.

Christian Lenk, DZ Bank’s rates strategist said that “it is something I worry about.” “Where are there bond spreads so wide that the ECB can intervene?” is the million dollar question.

This is a list of stress indicators.

1. CANARY COALMINE

The ECB may have difficulty transmitting monetary policy if the demand from premium investors to buy bonds from low-rated countries rises above that of Germany. The so-called fragmentation threat could increase economic instability.

It is now at 200 basis points (bps) and Italy’s high-indebted 10-year bond yield gap with Germany is lower than the peak of more 300 bps in March 2020. This was after a populist Italian government clashed against the European Union about budget policy.

It is at the highest levels since May 2020, after increasing 65 bps in 2018. Talk has intensified about ECB spread-control measures; ING believes markets may test the resolve to push Italy’s spread down to 250 bps.

Graphic:Italy’s 10-year bond yield gap over Germany- https://fingfx.thomsonreuters.com/gfx/mkt/byprjdlrgpe/BTPspread1805.PNG

This spread led to a flurry of activity that prompted the ECB’s emergency stimulus plan in March 2020. It was launched because of fears over the currency bloc’s viability due to a financial panic caused by a pandemic.

2. INSURANCE POLICY

Although the price of insuring for a southern European debt default has increased to its highest level since 2020 credit default swaps are still lower than their previous peak.

Graphic:CDS in southern Europe creeping higher again- https://fingfx.thomsonreuters.com/gfx/mkt/akvezrqmkpr/CDS1805.PNG

A spread of CDS contracts between CDS contracts that were issued in accordance with the 2003 International Swaps and Derivatives Association (ISDA), and those under its 2014 guidelines is another indicator of fragmentation. This latter definition includes redenomination guidance and is subject to a premium.

Rabobank reported that there is a 64-bps gap between the two CDS contracts from Italy, which was about the highest since April 2020.

Richard McGuire is Rabobank’s Head of Rates Strategy. He notes that in 2018, the spread was twice as high. He said that investors should be more concerned about historical trends than being alarmed.

Graphic:Italy 2003 CDS vs Italy 2014 CDS- https://fingfx.thomsonreuters.com/gfx/mkt/byvrjdlkgve/ITCDSVSCDS.PNG

3. LIFE AFRICA 2013

It is worth looking at how investors trade bonds that were issued prior to 2013 and afterwards.

The European regulators stated that European government bond contracts needed to contain collective action provisions (CACs) in order for restructuring and a change of the currency of payment.

UniCredit believes that approximately 415 billion Euros of Italian bonds is not being covered by CACs.

A 2008 Italian bond that was issued before the ruling, and due to mature next year has seen 72 bps increase in this year’s yield. The same amount has been credited to a 1-year Italian bond, which was issued in 2022. It will expire 2023.

It is possible that the bond 2022 outperforms its CAC counterpart, which could indicate that there are fragmentation fears returning.