ECB Signals No Return to Crisis That Almost Split Euro Zone

(Bloomberg) -- The European Central Bank can’t stop the euro-area from sliding into recession but it may be able to prevent another devastating debt crisis that threatens the bloc’s survival.

The ECB’s 750 billion-euro ($800 billion) bond-buying plan -- equivalent to about 6% of euro-area GDP -- will make it easier for governments to embark on a spending binge to fight the coronavirus pandemic.

It has already pushed borrowing costs down across the bloc and, importantly, it narrowed the gap between the bond yields of stressed economies such as Italy and safer options such as Germany.

Less than a decade after surging yields almost splintered the currency union, policy makers are trying to get ahead of the curve. They’re taking steps to assuage concerns that the fiscal spending needed to protect companies and people during the pandemic could spark higher financing costs that hit the economy even more.

Governments have shown they’re ready to splurge. Italy has said it’ll spend 25 billion euros on direct stimulus, and more is likely to follow. France has pledged to guarantee up to 300 billion euros of bank loans to companies, while Spain has unveiled a 117 billion euro plan to help keep companies afloat.

Even Germany, which has long been reluctant to spend despite running a budget surplus for years, is reportedly creating a fund worth 500 billion euros to provide firms with loan guarantees and injections of cash.

Separately, euro-area officials are looking at activating the region’s bailout fund to help governments raise the cash they need.

What Bloomberg’s Economists Say...

“If they step up, the recession will be deep but short-lived. If not, there’s a chance the euro won’t survive it.”

-Jamie Rush, Maeva Cousin and David Powell. Read their EURO-AREA INSIGHT

While all those plans will need to be funded with higher bond issuance, in a bloc which has long worried about its debt burden, there is now a large buyer.

“Monetary policy and fiscal policy are now joined at the hip,” said John Taylor, a money manager at AllianceBernstein who said he’s now more comfortable holding the debt of peripheral economies. “Central banks have to keep borrowing costs extremely low to encourage governments to expand fiscal policy as needed. Without this dual approach, economic growth will not be able to recover from this sudden stop that is now taking place.”

Bank of America Merrill Lynch said the purchases by the ECB will more than cover the extra bond supply that’s likely to hit the market. They assume around 300 billion euros of new issuance, or around 2.5% of GDP. That’s just over half the increase in 2007-08 during the global financial crisis.

“If governments choose to restore investor confidence through a courageous fiscal package, the interaction between re-leveraging and QE could squeeze periphery and semi-core spreads to new record lows,” wrote BofAML strategist Erjon Satko.

Risks remain in the speed and execution of the ECB’s plan. It is already skewing its existing bond-buying program toward Italian debt, according to people familiar with the matter.

“If they don’t front-load purchases enough, they’ll be accused of not putting their money where their mouth is,” said Antoine Bouvet, senior rates strategist at ING Groep NV. “The pandemic will probably last for months but the risk to the financial system is now.”

‘Fully Prepared’

Some policy makers are said to be concerned that the ECB might have to raise its self-imposed limits on how much it buys. Those limits are intended to prevent the central bank breaching European Union law against monetary financing.

ECB President Christine Lagarde, however, insisted that the central bank is “fully prepared to increase the size of our asset-purchase programs and adjust their composition, by as much as necessary and for as long as needed,” according to an op-ed published Thursday in a range of European newspapers.

Italian bonds extended their rally, sending the yield on 10-year securities down 9 basis points to 1.65% at 1:03 p.m. Frankfurt time. German yields also dropped.

Lagarde’s vow this week that that there were “no limits” to the protection of the euro was a clear echo of her predecessor Mario Draghi’s promise to do “whatever it takes” to preserve the currency during the 2012 debt crisis.

Back then, Spanish and Italian yields rose above 7%. While current yields were far below those levels even during Wednesday’s selloff, the speed and extent of the dislocation had raised concerns they could continue to spiral higher if left unchecked.

“The response now feels credible, convincing and powerful,” said Citigroup Inc. strategists led by Jamie Searle. “This should bring some relief to European government bond markets and remove concerns over how extra supply would be absorbed.”

©2020 Bloomberg L.P.