Europe’s Bond Traders Fear ECB Muzzling Its Most Powerful Tool

(Bloomberg) -- Europe’s bond traders are wasting no time in showing European Central Bank’s President Christine Lagarde just how much they need the institution’s support, one day after she signaled the option of buying less debt, if warranted.

Italy’s debt markets are once again proving the focal point, on course for their worst week since April with fresh elections in the country still a possibility. That comes after Lagarde reiterated on Thursday that the central bank’s entire 1.85-trillion-euro pandemic stimulus package may not be needed. While she also said the program could “equally” be recalibrated, investors are concerned the message may translate into a slower pace of bond purchases.

It’s a phenomenon Goldman Sachs Group Inc. has called “peak ECB,” now that the bulk of the institution’s firepower to combat the coronavirus’ economic damage is possibly in the rear-view mirror. Such a stance would align with that of other major central banks, from the U.S. to Japan, that have signaled there is enough money currently in the system to support the recovery. And with European governments willing and able to embark on fiscal spending like never before, the conditions are ripe for higher yields.

“This is a tapering story,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc, off the back of the ECB decision. “Yields have to rise as this risk premium gets priced in.”

Spreads Checked

While Lagarde also said that some of the package would only be left unused if financing conditions stayed favorable and that “nothing is off the table,” Italian politics is threatening to test the central bank’s resolve.

By signaling a potentially slower pace of purchases, Commerzbank AG said that the institution has created a set of factors that mean it may actually have to accelerate its buying program.

“Ironically, the emphasized language of potentially not using the envelope in full may lead to the ECB having to buy more,” wrote strategists Michael Leister and Marco Stoeckle. “Such market moves are probably the key reason why the ECB will be reluctant to reduce volumes notably.”

Bonds Slumped

Italian bonds slumped Friday following a report from the Corriere della Sera that Prime Minister Giuseppe Conte could seek new elections. The 10-year yield was on course for a 12-basis-point rise this week, the most since the first wave of the pandemic. German securities are also set for a weekly slide, with yields having touched a seven-day high of -0.49% Thursday. The euro rose 0.1% to $1.2173.

Lagarde’s comments on Thursday came after people familiar with the matter said the ECB was buying bonds to limit the gap in borrowing costs between the region’s strongest and weakest economies. The central bank has specific ideas on what spreads are appropriate, according to one of the people.

That policy had kept a lid on the yields of the euro area’s most indebted nations, like Italy, whose borrowing needs ballooned in the pandemic.

Less Support?

But with a Brexit deal secured, vaccines being rolled out, and a landmark European Union fiscal package in the offing, the need for the ECB to continue offering as much support may be diminishing.

It’s a realization that echoes among traders across the world. Ten-year Treasury yields could nearly double to 2% by the end of this year, according to JPMorgan Asset Management, which expects the Federal Reserve to flag a tapering of purchases by year-end. Bank of Canada Governor Tiff Macklem said the economy was flush with stimulus, while the Bank of Japan sees a rebound starting in April.

The outlook for inflation, which has long been absent from the euro area, remains the key question. Five-year, five-year inflation swaps, a gauge of expectations for price rises over the next decade, have steadily climbed from their nadir in March 2020 to around 1.32% -- well below the ECB’s target of just below 2%. Euro strength, which could damp import costs, adds a further complication.

It’s possible that traders could push Europe’s bond yields even higher and test the ECB’s approach to retaining some of its firepower, according to Antoine Bouvet, senior rates strategist at ING Groep NV.

“It’s a nice hawkish trap the ECB is setting up for itself,” Bouvet said. “If they want to spend less, they need to announce that they will spend a lot. Otherwise the market will doubt and test their resolve.”

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