Borrowing costs

ECB policy tightening sends Eurozone borrowing costs skyrocketing

Eurozone borrowing costs have hit multi-year highs as the European Central Bank rein in its stimulus programs, underscoring the challenge for policymakers to try to calm inflation without upsetting bond markets.

The yield on 10-year German government bonds – a benchmark for eurozone debt markets – rose above 1% for the first time since 2015 on Tuesday, as investors braced for the ECB to stop trading. adding to its bond portfolio of 4.9 billion euros over the next few months, followed by a series of interest rate hikes, starting in July.

Investors are also demanding a bigger premium in borrowing costs to lend to riskier and more indebted eurozone countries at a time when many are already facing growing economic headwinds.

Italy’s 10-year yield spread over Germany, seen as a barometer of political and economic risks in the eurozone, climbed to 1.9 percentage points on Tuesday, its widest since the early stages of the pandemic when investors dumped riskier eurozone government debt.

“What we are seeing in the markets is the realization that ECB tightening is upon us,” said Rohan Khanna, fixed income strategist at UBS. “It is a double whammy for the most vulnerable sovereigns to raise funding costs just as growth expectations are being lowered. I think the market will try to push Italian spreads through [2 percentage points] to really test what the ECB is going to do about it.

Italy finds itself in the market’s crosshairs thanks to Rome’s huge debt load, which was pushed to a record high of nearly 160% of gross domestic product last year by the economic fallout from the pandemic.

Frederik Ducrozet, strategist at Pictet Wealth Management, said his “rule of thumb” during the eurozone debt crisis a decade ago was that the “danger zone” for the spread between bond yields at 10 years from Italy and Germany was above 2.5%. points. But he said “that pain threshold might be higher today, let’s say until [3 percentage points] for spreads. . . because the outlook for nominal GDP growth is higher”.

Eurozone governments are expected to issue almost as much additional debt this year as last year, but the ECB is expected to buy significantly less. Ducrozet estimated that the ECB would only buy 40% of net euro zone government debt issues this year, compared to more than 120% over the past two years. In Italy, net government debt issuance is expected to be around €80 billion this year, slightly lower than last year, and the ECB is expected to buy around 45% of it, down from 140% last year. .

Some economists say this will be manageable thanks to a combination of economic growth, high inflation, low interest rates and more than 210 billion euros in grants and cheap loans from the Next Generation stimulus fund. EU.

However, investors have been reassured by Italy’s relative political stability since Mario Draghi became prime minister in early 2021 and economists fear this could be disrupted by next year’s election if that leads to the departure of the 74-year-old former President of the European Central Bank.

Erik Nielsen, chief economic adviser at UniCredit, said: “Six months from now, I bet the conversation will be all about the Italian election and what happens after Draghi.”

“I am worried about Italy,” added Ludovic Subran, chief economist at Allianz, noting that the Italian economy shrank 0.2% in the first quarter compared to the previous quarter, and that it will be probably harder hit than most of its peers by an EU. embargo on Russian energy imports and China’s Covid lockdowns.

Italy has an average debt maturity of seven years and it can still refinance many longer-term bonds maturing this year at lower interest rates. But that could change if the recent rise in yields persists, Ducrozet said.

Ducrozet added that markets were still pricing in the “implicit assumption” that the ECB would step in to cap spreads on the debt of economically weaker eurozone countries if necessary. The central bank said it could be flexible in how it reinvests proceeds from maturities among the bonds it holds to combat any fragmentation in bond markets.

In addition, the ECB said it could introduce a “new instrument” to support countries facing a sharp increase in borrowing costs as rates rise. But Luis de Guindos, its vice-president, said last week that the board had “not discussed in detail a new anti-fragmentation program”.

The fact that such discussions, however vague, are taking place indicates that the ECB is nervous about the impact of tighter monetary policy on spreads in the Eurozone and particularly in Italy.

However, it will be difficult to design such an instrument without further blurring the line between monetary policy and the financing of public deficits, according to Robin Brooks, chief economist at the Institute of International Finance.

Instead, sensitivity to sovereign spreads is expected to slow the central bank’s shift to tighter policy, making it highly unlikely that the ECB will deliver the 0.9 percentage points in rate hikes announced by the markets this year, he argues.

“The normalization of ECB policy has always struck me as a fanciful thing,” Brooks said. “How do you do when you have these over-indebtedness? The markets say that having a debt to GDP ratio of 150% is a major problem. If they continue on this tightening path, I think you will see Italian spreads widen further, perhaps in a disorderly fashion.