For years, bond investors buying debt from riskier euro zone countries such as Italy have been comforted by the presence of the ECB’s backstop to borrowing costs. But a communication mishap at a crucial juncture has undone some of that confidence.
The European Central Bank stepped up to the plate on Thursday, offering fresh stimulus to support economies and banks reeling from the ravages of coronavirus, which among bloc members has hit already-fragile Italy the hardest.
But ECB chief Christine Lagarde then proceeded to spark the biggest daily jump in Italian borrowing costs since 2011 with a seemingly off-the-cuff remark that it was not the central bank’s job to help “close spreads.”
That was a reference to the yield spread or premium over German bond yields that riskier southern European countries must pay investors when they borrow. Lagarde’s efforts to row back and a wave of reassurances from ECB officials on Friday have not done the trick, with Italy’s 10-year borrowing costs slipping only slightly from 8-month peaks.
So why exactly did Lagarde’s casual remark, blamed by some on her lack of central banking experience, dent bondholders’ confidence so much?
In short, the ECB’s 2.6 trillion euro asset purchase scheme along with crisis fighting measures such as the Outright Monetary Transactions (OMT) program, have helped underpin borrowing costs and encouraged investors into the bloc’s riskier bond markets.
“The ECB’s job is, in the strictest sense, not to ‘close spreads’,” said Aberdeen Standard Investments’ rates fund manager Ross Hutchison.
But, he added, its bond buying programs and ‘buyer of last resort’ status keep Italian bond spreads tighter than they should be based on debt and growth fundamentals.
“The ECB needs to be careful with its messaging to balance between not being seen to be underwriting moral hazard, but neither to be an idle spectator in a period of market chaos,” he said.
Hutchison, who is ‘underweight’ Italy but like other investors had made some purchases recently, said the damage done at Thursday’s ECB press conference would take more than reassuring comments to undo.
Italy’s 10-year bond yield at around 1.81%, has surged around 72 basis points this week -- its biggest weekly rise since 1994.
The Italian/German bond yield spread, at around 250 bps, is 60 bps wider than it was a week ago -- the biggest weekly spread widening since mid-2018 when an Italian political crisis sparked a bond market rout.
Spanish and Portuguese spreads over Germany have seen their biggest weekly blow-out since mid-2018 . French and Irish 10-year bond spreads are around 20 bps wider than a week ago.
“The perceived ECB backstop is showing cracks at the most difficult time for Italy,” said Christoph Rieger, head of rates and credit research at Commerzbank.
ING analysts predicted the Italy/Germany spread to test 300 basis points -- levels last seen in 2018. That’s when serious concerns about the health of Italian banks, which own roughly a sixth of the country’s public debt, tend to set in, according to analysts.
These markets need to partially price out the “ECB put” that has been propping them up, ING added.
The ECB said on Thursday it will provide banks with loans at a rate as low as -0.75%, below the -0.5% deposit rate -- essentially giving them a rebate, and it will increase bond purchases by 120 billion euros this year.
This should be enough to shore up economic growth but investors said the effectiveness had been dented by miscommunication.
“Do you think that in 2012 when Draghi said he would do whatever it takes to save the euro, that he could solve the problems of the euro?,” said Francois Savary, chief investment officer at wealth manager Prime Partners.
“I don’t think so. Nevertheless he gave the right signal and that’s what matters at the time. Yesterday was a communication mistake and reduced the ability of investors to look at the details of the program.”
Former ECB chief Mario Draghi, whose “whatever it takes pledge” at the height of the bloc’s debt crisis in 2012, is credited with saving the euro.
Lagarde’s spread comment means investors may be more cautious, Mohammed Kazmi, a portfolio manager at UBP, said.
“I don’t think you can be as comfortable in the Lagarde backstop as much as Draghi’s “whatever it takes” backstop,” Kazmi added.