Borrowing costs

European Central Bank pledges support against market turmoil

A European Central Bank on the verge of raising interest rates for the first time in 11 years pledged on Wednesday to create an unspecified safety net in the market that could protect member countries against financial turmoil like the one seen during a debt crisis more than ten years ago.

Pressured by a sale of government bonds, the bank’s board called an unscheduled meeting to deal with worrying changes in the market following the bank’s decision to raise rates in July and September.

ECB bond purchases and historically low interest rates have kept borrowing costs low for businesses and governments. But those measures are coming to an end as the bank pivots to deal with record inflation of 8.1% in the 19 European Union countries using the euro.

The bank announced last week that it would raise rates to rein in rising prices, but did not offer any specific measure to end market turmoil caused by suddenly higher borrowing costs for developing countries. the most indebted EU countries, such as Italy and Spain.

Instead, the central bank simply said it would act if necessary against “fragmentation,” or excessively high borrowing costs that plague one part of the eurozone and not another. It is a complication to have one currency and one central bank for 19 countries.

The non-specific pledge to act has not been enough to satisfy government bond markets, and the “spread”, or the difference between what Italy pays to borrow and what financially strong Germany pays , began to increase.

These so-called spreads are a key fear indicator for the Eurozone. Spreads widen as investors sell Italian bonds, lowering their price and raising interest yields, which move opposite the price. Rising yields may reflect investors’ view that a country’s bonds carry more downside risk.

The ECB said it would speed up the development of “a new anti-fragmentation instrument” which could be considered for approval by the governing council. His statement did not say what that instrument would be.

The bank also said it could use the money it makes from maturing bonds it holds to make new purchases and fight excessive borrowing costs if some countries come under market pressure.

The ECB already has an emergency safety net in the bond market that could allow it to step in and buy the debt of a troubled country. The tool helped ease the debt crisis of 2010-2012 after the bank announced it as part of then-President Mario Draghi’s pledge to do “whatever it takes” to prevent the break-up of the euro zone.

But this programme, which should never have been used, may come with difficult conditions for reform and governments may be reluctant to turn to it.

Holger Schmieding, chief economist at Berenberg Bank, said “the current situation is different from the euro crisis of just over a decade ago” because countries have improved their growth prospects and that the ECB has bond market support in its back pocket if needed. Current conditions “should not present an imminent risk, even for fiscally-struggling Italy”, he said.

A senior ECB official, Isabel Schnabel, tried to ease market concerns on Tuesday, saying the bank “will not tolerate” unwarranted market rate hikes.

“Our commitment to the euro is our anti-fragmentation tool,” she said during a speech at the Sorbonne University in Paris. “This commitment knows no bounds. And our response record in times of need confirms this commitment.”

Interest rates on 10-year Italian government bonds rose from around 1.2% at the start of the year to 4.1% on Wednesday. The ECB’s pandemic support programs, including 1.7 trillion euros ($1.8 trillion) in bond purchases, have helped keep government borrowing costs low in the zone euro. This program ended in March, however, and markets are now eyeing interest rate hikes from record lows.

The surprise ECB meeting comes on the same day the US Federal Reserve is expected to announce its biggest interest rate hike since 1994. The European bank has followed the Fed and other central banks in raising rates to fight against decades-high levels of inflation, including the Bank of England, which has hiked rates four times since December and will meet again on Thursday.

But now the ECB has scheduled rate hikes for July and September and indicated that the September increase could be half a percentage point higher than usual.