The European Central Bank (ECB) faces grave threats to its
mandate. The Eurozone economy is on the precipice of recession just as the central bank
raises interest rates for the first time in 11 years. Business and consumer surveys are
the weakest they’ve ever been. Inflation, persistently high energy prices and the threat
of a gas cut-off this winter continue to weigh on the economic outlook. Meanwhile, the
political landscape has changed: Macron lost his majority in France, and Italian prime
minister Mario Draghi has resigned, forcing fresh elections this autumn.
Splintering of the Covid-era technocrat consensus is a worry, but
not insurmountable. The ECB has finally acted to raise rates but was forced to rush a new
instrument into existence to combat what it sees as the potentially dangerous
fragmentation in bond spreads.
At its July meeting, the ECB raised its three key interest rates
by 50bps, more than was expected, whilst also introducing its ‘anti-fragmentation’ tool,
designed to cap bond yields in heavily indebted countries within the bloc, in order to
prevent too much divergence in sovereign borrowing costs. The ECB wants to avoid panicked
selloffs in debt markets which could occur as investors fret what higher nominal interest
rates might mean for a country’s ability to repay its debt.
What was noteworthy was less the extent of the hike but the way
in which the ECB has abandoned further guidance. This is a big shift for the ECB, which
has for years been wedded to its forward guidance. Farewell to gradualism, farewell to
forward guidance – hello to meeting-by-meeting decisions. This points to greater desire
among the Governing Council to act swiftly, something they would need to do if, for
instance, there was a sharp sell-off in a country’s debt markets that needed its
attention.
The TPI is interesting as there appears to be no conditionality
attached to the scheme. The ECB said purchases are not restricted by any pre-set
conditions (
purchases are not restricted ex ante
) and the scale of TPI purchases “depends on the severity of the
risks facing policy transmission”. Getting the anti-fragmentation right is key to being
able to raise rates. “By safeguarding the transmission mechanism, the TPI will allow the
Governing Council to more effectively deliver on its price stability mandate,” the ECB
said.
TPI seems a little fuzzy. It’s open to all countries…though we
know really, it’s aimed at Italy and a couple of others. And EU fiscal and debt rules need
to be adhered to, so it’s not a free pass as such. It’s a bit of a Schrodinger’s cat
policy – it’s there and not there at the same time. Which is what the ECB is hoping for.
The aim I guess is that the existence of the policy is enough for it not to need to be
used. Markets said otherwise with Italian-German spreads widening in the immediate
aftermath of the meeting.
TPI purchases would be focused on public sector securities
(central/regional government debt) of between one- and ten-years’ maturity. The ECB would
“conduct purchases under the TPI pursue sound and sustainable fiscal and macroeconomic
policies”, which sounds rather vague. Purchases under the TPI would be conducted such that
they cause
“no persistent impact on the overall Eurosystem balance sheet
and hence on the monetary policy stance”.
ECB president Lagarde stressed that TPI would be activated at the
sole discretion of the of the Governing Council, and she made a point of saying that the
reasons for activation would not necessarily be made public.
Countries will need to meet four key criteria:
-
Firstly, compliance with the EU fiscal framework. The risk is
that fiscal problems in a country actually means the ECB has to step back, creating
more volatility in the nation’s debt markets.
-
Absence of severe macroeconomic imbalances
-
Fiscal sustainability. Italy’s debt-to-GDP is 150% – is that
defined as sustainable? What if rates move up sharply, making repayments an even
larger % of GDP?
-
Sound and sustainable macroeconomic policies…
Should we worry about Italy?
Spreads between Italian and German 10yr paper have widened
markedly this year, by around 100bps. The toppling of the Mario Draghi government only
adds to concerns, with fresh elections set for September 25
th
creating uncertainty for investors.
Specifically, there could be a concern if Italy’s new government
were not to adhere to any of the four TPI criteria. Moreover, if a new government were to
miss ditch all or parts of planned structural reforms, it could cast doubt on Rome’s
access to €200bn of Covid recovery funds.
The worry – as noted after last week’s ECB meeting – is that
structural reforms required to get access to funds will be delayed or scrapped, which
could put further pressure on Italian debt and prevent the country from being eligible for
the TPI regime. This could become a vicious cycle for Italian debt markets. You could
envisage a scenario where a populist government ditches plans to make industries more
competitive, which sees Italy miss out on Covid funds and be barred from TPI purchases, in
turn leading to yields diverging further from core ECB debt markets.