Stefano Rebaudo and Dhara Ranasinghe

LONDON/MILAN, (Reuters) – After surviving the COVID-19 crises thanks to the ECB’s emergency stimulus package of 1.85 trillion euros, Greece, Spain, Portugal, and Portugal face a critical stability test as their scheme nears its end.

PEPP was a crisis program that gave the European Central Bank greater flexibility in purchasing bonds from member countries. It also complemented an older, but more flexible Asset Purchase Programme (APP), which has been in effect since 2015.

However, the PEPP (short for Pandemic Emergency Purchase Programme) will expire in March. Investors believe that the ECB needs to at least double APP purchases in order for it to be extended. Otherwise, the risk of spiraling borrowing costs for the periphery – a term used by the southern euro area states with the lowest incomes – is possible.

These countries were able to freely borrow money and not be penalized by the markets because of the ECB support. However, the equilibrium is unstable. Italian yields rose 13 basis points on October 29 due to fears about a rate increase by the ECB in 2022. This was the highest daily gain since April 2020.

“It won’t be easy to handle the end of PEPP March and prevent a hawkish misstep,” said Mauro Valle, Head of Fixed Income at Generali (MI 🙂 Investments Partners. Valle noted above-target inflation throughout the bloc.

Christine Lagarde, chief of the ECB has stated that asset purchases will remain important after March. However, hawkish ECB officials have already called for reduced bond-buying. Robert Holzmann from Austria suggests that net purchases may end in September. Klaas Knot, the Dutch chief of central banks, said, however, that ending PEPP does not imply an increase in APP.

This uncertainty could already be weighting; Italy’s yield spread relative to Germany, which is essentially what risk-averse investors want to hold Italian debt, has risen 20 bps to 120 bps over the last month.

GRAPHIC: DE-ITspread https://fingfx.thomsonreuters.com/gfx/mkt/zjvqkwdowvx/Pasted%20image%201637158451807.png

This is far less than the 300-bps-plus achieved last March before PEPP. However, Timothy Graf said that “peripheral spreads may have gotten to their tightest levels yet”. State Street (NYSE) Head of EMEA’s macro strategy.

The Spanish 10-year bond yields have increased 33 bps since 2010, the largest increase since 2010. However, Germany’s spread of 72 bps is approximately 10 bps higher than it was a month ago.

SUPPORT

It is possible to be confident that March 2020’s spread outbursts will not happen again. One is the 800-billion euro EU recovery fund, which disburses large amounts of loans and grants for southern Europe.

There are many positive signs for the economy: credit rating is improving, economies are recovering quickly and debt servicing risks are being managed with low yield levels.

GRAPHIC: Debt to GDP estimates, peripheral Europe vs Germany https://graphics.reuters.com/EUROPE-BONDS/egpbkablmvq/chart.png

Many are still skeptical that the ECB is able to prevent borrowing costs rising after PEPP expires.

It would be necessary to increase the amount of monthly Apps to 40-50 Billion Euros in order to continue to control the bulk of debt issuance. This is according to multiple banks.

Unicredit (MI:), estimates that in order to maintain stable financing conditions, the ECB needs to purchase assets of around 700 billion dollars by 2022. This would mean that APP should be doubled from March to year-end, at 500 billion euros.

Although this would still be less than what was spent on the year so far, Unicredit claims that a doubling the APP in conjunction with the ending of PEPP is not a feasible prospect, given the current mood at the ECB. A withdrawal by the ECB of monetary stimulation in the coming six months is already planned.

Italy is the most vulnerable market. NatWest projects 2022 bond issuance to be minus 26 Billion Euros net of ECB bonds purchases and redemptions – compared with this year’s minus 88 Billion euros.

Two other potential risks exist.

First, APP does not have the same flexibility as the PEPP. This allows the ECB’s flexibility to buy bonds according not to the economic size but to its capital key.

Second, speculation continues over interest rates.

Erjon Satko, BofA’s fixed income strategist said that if the markets value two rate increases next year that will indicate an end of ECB bond buying in 2022.

Satko stated that even if the APP rises to 40-50 Billion Euros per month, there will still be a positive balance between central bank net purchases and supply, which would amount to around 150 Billion euros by 2022.

The net bond supply would be expected to increase next year, possibly resulting in significant spread growth.

GRAPHIC: Life after PEPP https://fingfx.thomsonreuters.com/gfx/mkt/movanlbddpa/PEPP1711.PNG