Italy's Bond Investors Have a New Heroine
(Bloomberg Opinion) -- The European Central Bank has realized finally that it needs to get ahead of the financial markets and set the agenda.
By raising its Covid-19 response to an awe-inspiring total of 1.35 trillion euros ($1.5 trillion), it certainly managed to shock even those investors who were expecting an expansion of its pandemic quantitative easing program. For now, more QE is the message — a lot more. Combined with the European Union’s still-to-be-agreed 750 billion-euro recovery fund, this all smacks of a much more coordinated fiscal and monetary response in Europe, something people have been seeking for years.
This ability to get political leaders on board during a crisis is why Christine Lagarde, a former French finance minister, was chosen as ECB president. There wasn’t full approval from the central bank’s governing council on this expanded package — the decision was a “broad consensus” — but Lagarde was assured in her delivery. She’s evidently feeling more comfortable in the role after her miscommunication in the early part of the crisis, when she suggested it wasn’t her job to protect weaker nations’ bond yields.
The peripheral European countries’ bonds certainly loved her more aggressive approach on Thursday. Yields on 10-year Italian debt tightened by 20 basis points when compared with those of Germany. The euro jumped on the day as well.
Lagarde didn’t dwell on the possibility of buying junk bonds, which she said hadn’t been discussed. She emphasized that the ECB had “massively” front-loaded its debt purchases under the pandemic plan and overbought Italian bonds in the first weeks of the program to calm markets. The early investor fears about the ECB's response and its ability to act are being laid to rest.
Nevertheless, the ECB’s quarterly economic forecasts for the euro area remain highly optimistic, predicting a sharp recovery in the third quarter and a drop of 8.7% in gross domestic product this year that’s almost totally recovered by the end of 2022. In these highly uncertain times, this is just guesswork. The ECB is sticking to a positive message in the hope that it might will a V-shaped recovery into existence.
Lagarde repeated several times her desire to return to the ECB’s central mission of getting the euro zone’s inflation close to 2% (something it was failing to achieve pre-Covid). Even with the huge wave of stimulus, her 2022 inflation expectation is only 1.3%. It was telling that for the first time the increase in bond buying was linked directly to inflation forecasts. This might have been an attempt to satisfy the demands of the German Constitutional Court, which wants the ECB to justify its existing QE programs.
The European economy was close to recession before the virus hit, a poor position from which to enter a crisis. Nonetheless, Italian yields have largely recovered their equilibrium since the early days of the outbreak, meaning the country’s borrowing costs remain manageable. The ECB is doing a good job in mitigating the pandemic’s fallout. Lagarde needs to ride the current wave of market euphoria for as long as she can to make sure that government bond yields are low enough to allow a recovery. So far she’s deserving of high marks.
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
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