When Christine Lagarde remarked in March that it was not up to the European Central Bank to narrow the gap in borrowing costs between the strongest and weakest members of the eurozone, she poured fuel lighter on a bond market liquidation.
Nine months later, investors have gone all-in on the bets that the ECB boss has changed her mind and is here “close the spreads” after all.
Ahead of the next central bank policy meeting later this week, spreads in the so-called eurozone periphery have been smothered by relentless demand for riskier bonds. The purchase helped push Portugal’s 10-year yield subzero last week for the first time. Spain is not to be outdone and Italy – the last major market in the euro area to offer a significant positive return over a decade – has seen its spread closure the lowest since the region’s debt crisis ten years ago.
While the ECB is expected to expand its emergency asset purchase program of 1.35 billion euros on Thursday by an additional 500 billion euros, investors are increasingly relaxed about holding peripheral bonds despite the explosion in debt levels caused by the pandemic.
“The commitment to keeping spreads low has impressed markets this year,” said Sandra Holdsworth, UK Global Rates Manager at Aegon Asset Management. “Why wouldn’t you buy Portuguese or Italian bonds if you know they have the backing of the central bank?”
The ECB has avoided explicit targets for bond yields or spreads, with board member Isabel Schnabel telling Bloomberg last week that policymakers had never discussed “control of the yield curve” – a policy aimed at maintain yields at a predetermined level. But for some investors, its commitment to preserving “favorable financing conditions” is the same.
“The ECB is carrying out a sort of control of the yield curve and spreads,” said Isabelle Vic-Philippe, head of euro government bonds at Amundi, Europe’s largest asset manager. “They can’t say that, but that’s what they do, frankly.”
Indeed, markets appear to have much more confidence in the ECB’s spread-closing powers than in its ability to fulfill its mandate of an inflation rate of just below 2 percent. Five-year inflation-linked swaps – a long-term market indicator closely watched by the central bank – show investors expect consumer prices to rise only 1.25% per year during the second half of the next decade.
A stronger euro, which lowers import prices, doesn’t help: The common currency rebounded to over $ 1.21 last week, its highest level since April 2018. ECB officials have already signaled their concern about the gains, which partly reflect general dollar weakness, but investors are skeptical whether the central bank can curb the rise just by trying to drive the currency down.
“The problem with verbal intervention is that it only works for a while,” said Jane Foley, head of FX strategy at Rabobank. “Then you have to save it.”
As long as investors view the ECB’s asset purchases as a tool to limit spreads, rather than lower interest rates across the economy, this is unlikely to change, he said. she declared. The central bank has not ruled out cutting its policy rate from the current record level of minus 0.5%, but few investors expect it to take that step.
“Stocks speak louder than words: we have the biggest shock to living memory activity and they haven’t cut the key rate,” said Richard Barwell, head of macro research at BNP Paribas Asset Management. Reluctance to cut rates in the face of sub-target inflation is fueling the euro’s rise, potentially creating a vicious cycle where slowly rising prices fuel the currency’s strength, Barwell said.
If the ECB is to meet its inflation target, it will need governments to step up their fiscal stimulus plans, he said. Ms Lagarde, since joining the Frankfurt-based institution last year, has urged euro area member states to loosen the purse strings and advocated coordination between monetary and fiscal authorities in responding to the pandemic.
By controlling borrowing costs, the ECB has given governments breathing space for more spending. However, relying on the indirect effects of its policies to achieve its central objective potentially puts the ECB in an awkward position, Ms. Holdsworth said.
“There are things Lagarde likes to talk about over which the ECB has no control, such as the need for additional budget support,” she said. “This tells you that they are fully aware of the limits of monetary policy, but they do not publicly admit that they are down the road.”