While the press and markets are understandably focused on parsing the brief statement on bond market fragmentation that was just released by the European Central Bank, we urge you to read the speech delivered yesterday by European Central Bank Executive Board Member Isabel Schnabel at the Sorbonne University in Paris addressing differentials in eurozone sovereign bond market yields (see below).
In addition to being one of the most influential thought leaders on the Governing Council, Schnabel is also the head of market operations for the ECB, making her speech on fragmentation risks that much more noteworthy.
As its title – “United in Diversity” – suggests, Schnabel reiterates that differential sovereign yields are, indeed, a fact of life in the eurozone, reflecting divergent national fiscal policies and economic conditions.
Going through the various cycles in the ECB’s history, Schnabel recounts periods of dangerously compressed eurozone sovereign yields, as well as the historic blow outs in southern European bond markets during the European debt crisis of 2010-12, putting the current widening of spreads in historic context in a series of charts in the appendix that are highly illustrative.
As to the current state of affairs, Schnabel reiterates the ECB position — which we have repeatedly written as well — that the ECB has dealt with fragmentation successfully many times in its history, can easily redirect Pandemic Emergency Purchase Program bond reinvestments as needed to surf any excess (peripheral) market volatility, can structure new facilities if and as needed for new situations, and that the ultimate backstop against eurozone fragmentation is the ECB’s unwavering and unquestioned commitment to the euro.
This morning, the ECB convened an emergency session of the Governing Council to address the recent volatility and sharp rises in peripheral (led by Italian) bond yields, in no small part fueled in the last few days by the dramatic sell-off in US markets in the wake of the disastrous US CPI and University of Michigan inflation reports last week.
At the conclusion of today’s meeting, the ECB announced exactly what it has been telegraphing to anyone that has been listening to them, that in a bid to smooth out some of the excess volatility in peripheral markets:
…the Governing Council decided that it will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate. In addition, the Governing Council decided to mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council.
This statement, which sheds no light on what a new facility may look like, may disappoint some traders who have been led by journalists for about three months to believe the ECB was about to roll out a new facility any day now. But more importantly, it should put to bed any notion that the ECB is powerless or unwilling to address fragmentation, or, for example, speculation that 4% Italian BTP yields could augur some sort of existential threat to the euro.
On that note, while markets may be less interested in fundamentals than in gaming interventions, it is worth noting a couple of important points on the former that Schnabel made in her speech yesterday.
The first is that through the pandemic, eurozone national authorities have taken advantage of low yields to reprofile their debt towards longer dated maturities. This not only locks in low rates and lowers sovereign issuers’ vulnerability to rising short term rates as the ECB embarks on its tightening cycle, it also represents a windfall (our words, not hers) in a high inflation environment.
The second is that the Next Generation EU program is designed specifically to direct funds to eurozone states that are most in need, acting, in effect, as an important fiscal stabilizer for the eurozone.
For those interested, we have attached a full link to the speech below. The speech and accompanying slides are also available on the ECB’s website: