This morning has brought news in what we need to know consider as the first line of defence for the bond market of Italy ( and one or two others). Regular readers will recall that there was a plan to reshuffle existing purchases to boost the periphery. The Financial Times describes it below.
The European Central Bank is using its pandemic-era bond-buying programme to shield highly indebted eurozone countries from the effects of its decision to unwind stimulus programmes in its bid to fight inflation.
The central bank concluded net purchases under its pandemic emergency purchase programme in March, but is focusing reinvestments of maturing bonds on the bloc’s more financially fragile members.
This is especially revealing because if we look at the period in question it has been a good one for bond markets with yields falling. So stresses and strains should have been lower. For example the ten-year yield in Germany peaked above 1.8% in the middle of June and is now 0.9% so the trend has clearly been for lower bond yields. We have looked at this elsewhere and it has been a noticeable feature of western bond markets. So even in relatively good times there seems to have been a problem.
The next question is of course, how much?
Between June and July, the ECB injected €17bn into Italian, Spanish and Greek markets, while allowing its portfolio of German, Dutch and French debt to fall by €18bn, according to Financial Times calculations based on the central bank’s data.
Previously a maturing French bond for example would see the funds reinvested in other French bonds to maintain the stock. But now the money is being spent on Italian, Spanish and Greek ones. Probably not too much on Greece as so much of its debt is already held by the ESM ( European Stability Mechanism). In the period in question the main exchange if I may put it like that was from German debt to Italian debt.
Why does this matter?
The issue is that the ECB is backed by some 19 different national treasuries so there has to be a balancing of the risk for national taxpayers. There is no other central bank quite like this as they usually deal with the national treasury. So a “capital key” has been calculated which in broad terms represents the relative size of the various economies and that has been how the ECB splits its purchases. But now it is moving away from that meaning that the core nations are helped less to favour mostly Italy.
What has been the scale of the problem?
There has been an underlying problem for a while but it has been added to by the fact that the ECB has begun to raise interest-rates. Such fears were probably behind the ECB Forward Guidance announcement that it would raise interest-rates only by 0.25% in July. We now know that in the last days they changed to a 0.5% move. At that point this will have been their concern.
These fears pushed wider the difference between Italian and benchmark German 10-year bond yields to as much as 2.4 percentage points in June, a level last seen during the market tumult in the early days of the pandemic in 2020. ( FT)
This morning the spread is at 2.13% and has slightly deteriorated over the weekend with German yields following the US ones lower but Italy nudging slightly higher. That may simply be technical as the ECB buying is often later in the day.
As to the level that is considered to be the threshold for the new policy called TPI or the Transmission Protection Instrument the FT suggests this.
Investors have been watching Italian spreads cautiously to see when the ECB may step in, with many deeming 2.5 percentage points an important mark.
The Italian Job
The issues for Italy essentially come from our “Girlfriend in a Coma” theme. Over the whole Euro era economic growth has been both weak and rare which has meant that debt relative to economic output has kept rising. The forecasts are pretty much always for a drop but to give an idea the 120% debt to GDP threshold was announced for Greece to avoid embarrassing Italy ( and Portugal). Whereas at the end of the first quarter the ratio for Italy was 152.6% and the debt was 2.76 trillion Euros.
As both the absolute and relative debt levels have risen this has been the state of play.
A false narrative in the Euro zone is that Italy’s debt overhang is a “stock” problem due to past excesses, while Italy now runs primary surpluses. The data say this is clearly wrong. Italy is a “flow” problem. The ECB has had to fund its deficit for the past 6 out of 7 years… ( @RobinBrooksIIF )
As ever there is a debate over definitions but his numbers show that during the pandemic years the ECB via the Bank of Italy bought more bonds than were issued and especially so in 2021. Also if we look back we see that in 2015 16 and 17 it bought more bonds than were issued. That raises a wry smile as we wonder if that was one of Mario Draghi’s aims when he began mass QE in the Euro area?
There are a couple of ironies to this state of play. Over the pandemic period France has replaced Italy as the largest Euro area bond market. Also the latest Italian growth figures told us this.
In the second quarter of 2022 the seasonally and calendar adjusted, chained volume measure of Gross Domestic Product (Gdp) increased by 1 per cent with respect to the previous quarter and by 4.6 per cent over the same quarter of previous year. ( Istat)
This means that economic output in Italy is now slightly above pre pandemic levels.
Comment
The present situation poses various questions. Of which the first is whether the ECB can ever leave the Italian bond market? Since 2015 it has stepped in and there have been two main impacts. Firstly the bond yield has been suppressed and secondly Italy has been able to issue its debt, although there was something of a crisis in March 2020,especially after ECB President Lagarde announced this.
Lagarde: We are not here to close spreads, there are other tools and other actors to deal with these issues. ( ECB)
Or to put it another way courtesy of The Eagles.
Relax, ” said the night man
“We are programmed to receive”
“You can check-out any time you like”
“But you can never leave!”
For the Euro area there is the issue that the debt held by its central bank will shift towards the economies that are considered to be weaker. There is an interesting balance here as usually in its holdings the split is 82% on the national central banks and 18% on itself.
The conventional metrics are much better than you might think. The benchmark ten-year yield is just over 3% which historically is cheap. Inflation flatters debt calculations and roughly it is 8% so in a sense Italy is gaining here although care is needed as some of the debt is inflation linked.
The largest effect would be in Italy. In the 7.5% scenario the debt cost could increase by EUR12.7 billion (0.7% of GDP), given that Italy has the largest debt ratio and also the highest weight of linkers at more than 10%. In the 10% inflation scenario, Italy’s debt could increase by EUR18 billion – 1% of GDP. ( Fitch Ratings)
Also the economy has for once had a burst of economic growth. Yet the ECB still feels the need to oil the debt wheels. If the business surveys are to be believed then times are about to get harder.