In July 2008, with the global financial crisis trashing the world’s economy, then US Treasury Secretary Henry Paulson asked legislators for the power to grant unlimited credit to his country’s mortgage agencies: “If you have a squirt gun in your pocket you may have to take it out; if you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out.” Given what’s happening to government bonds in the euro zone, the European Central Bank may want to start building a bazooka of its own.
With inflation in the bloc running at four times the central bank’s target, the rise in European yields this year is entirely logical, and the debt market selloff has been pretty orderly. But the risks of fragmentation are growing as the yield premiums of peripheral nations soar compared with Germany. When a 10-year bond loses a fifth of its value in six months, it is typically a sign of distress on the part of the borrower. This is happening not to some struggling company, but to Italy, Europe’s third-largest economy.
With Italy’s 10-year borrowing cost now reaching 4%, its highest level since 2014 and quadruple where it started the year, questions are starting be asked about the nation’s debt sustainability. The gap with Germany has climbed above 230 basis points, to a two-year high. The rise in Italian yields has been relentless this year, across the maturity spectrum.
It’s hard to specify at what interest rate investors will start to ask whether the nation will struggle to make its payments. But the memory of the euro-zone debt crisis a decade ago, when Italy’s yield climbed above 7% and the future of the entire common currency project looked in peril, remains fresh in the minds of policy makers. And while the pandemic has increased debt-to-gross-domestic-product ratios across the bloc, Italy remains more indebted than the region as a whole.
Moreover, about a third of existing Italian government bond debt worth more than 850 billion euros ($910 billion) falls due in the next four years, with almost 290 billion euros of interest and principal payments needing to be refinanced next year alone. Clearly, this needs to be rolled over at affordable levels; Italy currently pays a weighted average interest rate on its borrowing of about 2.5%, according to data compiled by Bloomberg.
For sure, the growth side of the debt-to-GDP ratio is a key part of the picture, and the more consensual post-pandemic approach across the European Union to government borrowing stresses and the 800 billion-euro Next Generation recovery fund are important fiscal game changers. A second iteration of the NextGen fund may emerge before long if the euro-area economy threatens to slide into recession.
More immediately, the big monetary question is when will the ECB cavalry turn up with an anti-fragmentation plan to defend the borrowing costs of peripheral nations, with Greek yields up ninefold in the past year and Spanish and Portuguese bonds also suffering. Investors have taken fright at the triple whammy of bond-buying coming to a halt, the imminent arrival of sustained official interest-rate increases and the withdrawal of super-cheap subsidies for commercial bank borrowings from the central bank. President Christine Lagarde learned a hard lesson at the start of the pandemic that it pays to speak carefully when discussing bond spreads.
The ECB’s belated desire to tackle inflation risks a lot of stimulus getting withdrawn simultaneously, potentially leading to a credit crunch if financial conditions contract too quickly. As a paper prepared by the Bruegel group for the European Parliament shows, discussions are understandably underway to prepare for ongoing potential emergency measures. Unfortunately, there was little mention at last week’s ECB meeting of what might be introduced to fend off ”the gentlemen of the spread”. Furthermore, despite Lagarde’s repeated assertions about quantitative easing’s reinvestment flexibility, analysts at Bloomberg Economics reckon the program could be easily overwhelmed if Italian yields climb much above 4%.
During the euro debt crisis a decade ago, then ECB President Mario Draghi gradually restored control using a combination of powerful rhetoric and the threat of a big stick in an ultimately unused program called Outright Monetary Transactions. It came with a bunch of unacceptable restrictions for sovereign countries, which the pandemic QE program was skillfully able to overcome. But that was then — different measures are required now in the form of an anti-fragmentation debt-support plan to prevent the euro’s more financially vulnerable members getting separated from their wealthier neighbors.
It may seem bizarre for the ECB to announce the end of asset purchases last week only to create a new bond-buying vehicle swiftly after. But needs must, and the Governing Council can be proactive in reassuring financial markets that it can raise rates and withdraw stimulus while at the same time building a mechanism to limit the inevitable bond-market fallout of its newfound enthusiasm for tighter policy. Policy makers need to get creative in the coming months; if they wave a bazooka convincingly enough, the scramble of buyers for cheap Italian debt will do a lot of the heavy lifting.
More From Bloomberg Opinion:
• The ECB Is No Longer an Inflation-Targeting Central Bank: Richard Cookson
• Central Bankers Don’t Know How to Tackle Inflation: Mark Gilbert
• Memo to Fed: Hurry Up and Hike So We Can Slow Down: Daniel Moss
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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