ECB backs away from hawkish path, but how long will it last?

Southern European bond markets were in focus at the start of the week, as Italian and Greek bond yields surged and their spreads with German debt rose to multi-year highs. Spanish bonds also rose to an intraday high of 1.13% before easing off. This led to some analysts speculating that a taper tantrum was taking place, after last week’s ECB meeting suggested that the bank was shifting to a more hawkish stance more in line with the Fed and the BOE. On Monday, ECB President Christine Lagarde tried to dial back her comments from Thursday and said that the market did not need to rush to a premature conclusion about what the ECB’s future policy path would look like, and that the future was far too uncertain. Even so, this shift in some European bond prices caused jitters in the market and could determine European asset prices in the short term. 

Is a Eurozone debt crisis on the cards? 

The move in Italian and Greek bond yields in the last three sessions brought back some uncomfortable memories from the Eurozone debt crisis in 2010/2011. The speed of the move higher in yields was astonishing. Italian 10-year yields had traded at 1.28% a week ago, they closed Monday’s session at 1.81%, after falling back from a high of 1.89% earlier. Greek bonds have also sold off sharply causing yields to rise from 1.91% last week, to 2.48% at the start of this week. The spread between 10-year Italian and German yields is now 1.59% and   with Greek yields it is 2.26%. The question now is, what is going on and is a debt crisis likely? Below we weigh up both sides of the argument and also let you know the market view. 

ECB: no more buyer of last resort

There are reasons to be pessimistic about the bond markets in Italy and Greece. Firstly, they have benefitted massively from the ECB’s enormous bond buying scheme. In the past two years it has bought more than 100% of debt, net of refinanced bonds, issued by the Eurozone. The ECB now owns a total of EUR 4.7trn bonds. Thus, it is not only a buyer of last resort, but has been the only buyer of some Eurozone debt in recent years. it is still buying EUR 20bn of bonds a month, as it tries to scale back its purchases. If the ECB starts to normalise/ tighten monetary policy in response to surging inflation in the currency bloc, not only will it stop buying these bonds, but at some stage it should consider the prospect of shrinking its balance sheet. The Fed has started to signal that it could shrink its balance sheet at the same time as tightening interest rates, the market is starting to worry that the ECB could do the same. 

Negative interest rate policy to be cast out to annals of history 

This aggressive bond-buying from the ECB caused Italian and Greek bond yields to fall to multi-year lows last year, Italian 2-year yields fell into negative territory in July 2020 and only started to move into positive territory at the end of January; even Greek 2-year yields slipped into negative territory. While the market may have been complacent back then, the recent swing to the upside in southern European debt highlights the large reassessment that is currently taking place in the Eurozone bond markets: it is pricing in the prospect of an end to the ECB’s negative rates policy, and the most indebted nations will suffer the most. Of course, the market is always prone to overreact. After the hawkish shock from the ECB last week, the market is now pricing in the prospect of a rate increase from the ECB as early as June, which we think is far too early. Even the traditionally hawkish Dutch ECB member Klaas Knot said that interest rates should rise, but not until the end of this year and then the Bank should hike again in Q1 2023. This is hardly an aggressive pace of tightening; however, he is one of a growing chorus of Northern European ECB members that are calling for the ECB to stop net asset purchases as soon as possible in preparation to raise interest rates. 

Stocks: resilient to bond market pressure so far 

The market impact of the gyrations in the Eurozone bond market have been fairly limited to the debt market so far. European bourses held up fairly well, with London, Germany and France all gaining between 0.7% and 0.8% on Monday. In the US session, volatility rose, and US stocks gave back earlier gains as the markets wait for US inflation data later this week. Analysts are expecting headline inflation to rise to 7.3%, a fresh 40-year high, with the monthly rate rising by 0.5%, however, monthly core inflation could see its pace of increase cool slightly to 0.5% from 0.6%, although the annual rate is expected to move higher to 5.9% in January from 5.5% in December. The moderation in monthly core price data may not give investors much to cheer about, as it will take much more than this to bring annual rates of inflation back to the Fed’s target rate. However, it could be a sign of things to come, as annual price comparisons start to improve later this year. Investors are caught between the cross hairs of strong economic data, US payrolls data was much stronger than expected for January, and rising inflation. At this stage, it looks like fears about the pace of interest rate tightening are dominating market moves, and this is causing volatility. As the ECB becomes more hawkish, it is focussing minds that a record amount of monetary stimulus is about to be withdrawn from markets, which is putting people off risk: the Nasdaq is down more than 10% YTD, while the S&P 500 is down approx. 5%. While European indices have outperformed their US counterparts so far this year, we think that fears of a sovereign debt crisis in Europe’s periphery could see a slowdown in gains for some European indices, especially if the ECB does not do a better job of taming fears about a rampant rate-hiking cycle. 

Why the euro could come under pressure this week 

In the FX space, the euro has remained surprisingly resilient in recent sessions, suggesting that either the FX market is moving purely on expectations of a faster pace of rate increases for the currency bloc this year, or that it doesn’t think that a sovereign debt crisis will happen. We think that the truth is somewhere in the middle. After Lagarde stepped back from last week’s hawkish comments in a speech on Monday, this triggered a small pull back in southern European bond yields. Counter intuitively, this could weigh on the euro on Tuesday, as the market reassesses the prospect of ECB rate increases later this year. Short term support for EUR/USD lies at $1.1415-20, below here opens the way to $1.14, if we see a deeper decline, then it is worth remembering that the 50-day moving average, a key medium -term support level, lies at $1.1317.