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| 17 minutes ago
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European bond markets have been particularly volatile in recent weeks as the general slide that began later last year has deepened. The stagflationary shock triggered by the Russian-Ukrainian conflict was a major factor in the deterioration, adding to the supply chain constraints associated with the pandemic. According to the Bloomberg Consensus Forecast, growth forecasts for the Eurozone in 2022 have fallen to 2.7% from 4.4% in September 2021. At the same time, inflation in the Eurozone has accelerated from 3.5% to 8.6%. This represents an unprecedented deterioration in the macroeconomic outlook.
As a result, and despite the slowdown in growth forecasts, the European Central Bank (ECB) came under pressure to tighten policy and stick to its 2% inflation target. In fact, at its last monetary policy meeting, the ECB decided to opt for a “hawkish” policy, tightening rates by 50 basis points (bps) instead of the expected 25 bps. This is the first increase in the ECB’s key rate for more than ten years. Importantly, this move pushed the ECB deposit rate out of negative territory for the first time in seven years.
However, monetary tightening in the euro zone could be difficult. The macroeconomic situation varies from country to country within the monetary union, particularly with regard to budgetary needs and debt levels.
Fiscal situation of euro area countries as % of GDP
(y = reverse public debt; x = five-year average deficit to 2022)
Sources: Haver, IMF, analyse QNB
Southern Mediterranean countries or the “periphery” of the euro zone, such as Greece, Italy and Spain, have larger budget deficits and accumulate higher debt levels than northern economies (Germany, Austria, Belgium and the Netherlands), more fiscally conservative. Consequently, southern European economies are more vulnerable to more aggressive ECB tightening, as higher interest rates increase debt burdens, potentially creating unsustainable sovereign credit dynamics. In fact, when further rate hikes were priced into the markets, yields began to soar in all countries.
German 10-year Bunds have jumped more than 130 basis points (bps) since the end of last year. More importantly, over the same period, spreads between German Bunds and Southern European countries’ bonds have widened significantly, approaching stress levels last seen in the depths of the pandemic crisis. . Italy and Greece present the most difficult position, their spreads having widened by 130 and 100 basis points, respectively. According to different measures of debt sustainability, the current yields of Italy and Greece may well be enough to trigger a new round of discussions on the debt crisis in Europe.
Spreads between Eurozone periphery 10-year bonds and German Bunds
(%, 2020-2022)
Sources: Bloomberg, analyse QNB
Tighter sovereign debt markets in the “periphery” of the euro have already necessitated action by the ECB. In mid-June, the Governing Council of the ECB convened an emergency meeting to discuss so-called “anti-fragmentation” measures, i.e. political actions intended to support countries in difficulty and to protect the integrity of the monetary union. In practice, these measures meant that maturing ECB assets could be reinvested disproportionately in the bonds of troubled sovereigns and that more funds had to be made available to provide a safety net for the “periphery”. ”. The outcome of these discussions materialized at the recent monetary policy meeting, when the ECB announced the establishment of a “transmission protection instrument” (IPT) to counter “unwarranted market dynamics and messy”.
For some analysts, these new measures are only the expression of the difficulty of normalizing monetary policy in the euro zone. In our view, the emergency meeting made it possible to lay the foundations for the creation of the tools necessary for a “decoupling” of the actions of the ECB. This means that the overall normalization of policy aimed at fighting inflation and creating price stability will most likely be deployed in the Eurozone through more aggressive interest rate hikes. On the other hand, to avoid an aggravation of the tensions in the countries of the “periphery”, the ECB reserves the discretionary power to use and reallocate the quantitative tools to support the more fragile economies of the euro zone. In this sense, it is not surprising that the ECB has decided to adopt a more aggressive rate of tightening.
Overall, we expect to see a more active ECB in the second half of the year. A potential solution to the euro zone’s “macroeconomic divergence problem” opens the door to more aggressive policy rate hikes while preventing more severe shocks and a possible euro zone sovereign crisis. We expect the Governing Council of the ECB to raise rates by 50 basis points at subsequent meetings in September and October, before slowing to a more normal pace of 25 basis points in December. This may just be the start of a historic normalization process.
Source: Press release
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