The outlook in Europe is looking rather grim at the moment. A looming energy crisis, made worse by the Russia-Ukraine conflict, adds to worsening economic conditions brought about by surging inflation pressures. And now, you can start throwing in a debt crisis into the picture again.
ECB president Lagarde failed to address any concerns regarding fragmentation in the euro area yesterday and that is seeing the central bank welcome back an old friend as it prepares to tighten monetary policy for the first time in over a decade.
Let’s take a look at the problem.
What exactly is fragmentation or in this case, financial fragmentation?
It is when the monetary policy effects of the ECB is not equally felt across all countries in the Eurozone, leading to significant widening in spreads that are a signal of disconnect from the economic backdrop. As such, the blow up of the BTP-Bunds yields spread is a key barometer to watch in that regard.
The question as to why the effects are not going to be equal lies in the root of how the Eurozone framework is constructed and that’s another issue altogether.
But for the sake of this post, let’s keep the focus on fragmentation and what risks that may present to markets.
At the height of the European debt crisis in 2012, then ECB president Draghi famously coined the term “whatever it takes” in bringing down the blow up in spreads at the time. So, how have we come back to that?
The easy thing to point towards is the ECB starting to tighten policy again for the first time in more than a decade. Fittingly, bonds will sell off as the central bank pivots on policy and prepares to end asset purchases.
However, the key issue here is that periphery bonds (like Italy) are selling off much faster than their counterparts (like Germany).
Back in 2012, the more accommodative ECB policy allowed for an emergency bond-buying program called OMTs. A key problem for the central bank now is that how are they supposed to go about buying more bonds (specifically Italian bonds) when they are moving on to tighter policy. And let’s not even get started on how this would even play out if quantitative tightening were to be introduced.
While the 10-year BTP-Bunds yields spread hasn’t blown up to levels seen during the height of the last debt crisis, the fact that the ECB lacks a game plan and may struggle to find a solution is reason enough for bond markets to feel jittery.
ECB president Lagarde said previously that they are “not here to close the spreads” and that they are prepared for markets to “test our resolve as much as they want”. Well, she is going to get precisely that in the months ahead until they present some idea on how to tackle this issue.
As much as rising yields from the ECB tightening policy looks like a tailwind for the euro, the blow up in spreads ultimately signals risks to financial stability and that will in turn be a major headwind for the single currency instead.