Italian and Greek borrowing costs hit multi-year highs on Friday as investors were rattled by a hawkish European Central Bank meeting that is increasing pressure on the finances of Europe’s most indebted countries.
The yield on Italian 10-year bonds hit its highest level since 2014, at 3.75%. The Greek 10-year bond rose 0.23 percentage point to 4.28%, surpassing the level reached at the height of the Covid-19 pandemic.
The ECB on Thursday confirmed its intention to end its bond-buying program and raise interest rates for the first time since 2011 next month, and hinted that more aggressive rate hikes could follow later in the year.
The move to tighten monetary policy as the central bank seeks to rein in record inflation has reignited investor concerns about the ability of weaker members of the euro zone to sustain their massive debt loads without support from the ECB.
Spanish and Portuguese debt were also hit, while the sell-off spread to shares in European banks, many of which are highly exposed to a debt run-off due to their holdings of government bonds.
Italy’s main stock index fell 5%, led by the banking sector. Lenders UniCredit and Intesa Sanpaolo lost 9% and 7.6% respectively.
Crucially, ECB President Christine Lagarde said on Thursday that the central bank could introduce a new tool to avoid “fragmentation” of the eurozone by limiting sovereign borrowing costs, but provided few details. She also reiterated that the central bank may reinvest the proceeds of maturing bonds it holds to avoid stress in the bond market.
“There are big doubts about whether reinvestments can really help if things start to go haywire,” said Rohan Khanna, rate strategist at UBS. “There was hope before the meeting that they were working on some sort of new facility, but Lagarde hasn’t told us anything new. The big question customers keep asking is who will buy Italian bonds once that the ECB will back down.
The euro extended its decline on Friday, falling 0.9% against the dollar to hit a three-week low at $1.052. The currency had initially climbed after the ECB’s announcement on Thursday, but gave up gains as the market turned away from the prospect of higher interest rates in the euro zone towards renewed tensions in the bond market.
The spread between Italian and German 10-year bond yields, a closely watched indicator of market stress, widened as much as 2.27 percentage points on Friday, the most since May 2020.
Khanna said some investors had speculated the ECB could be forced back into the markets if that spread reached 2.5 percentage points – a level that prompted a central bank response in the early stages of the pandemic. .
“After what we saw yesterday, I think a lot of people are wondering if the level at which the ECB steps in and saves the day is now higher than previously thought,” he said.