Europe’s Favorite Risk Gauge Is Warning of Rocky End to Stimulus
(Bloomberg) -- The sharpest swings since the start of the pandemic in one of Europe’s riskiest debt markets is giving investors a taste of what’s at stake if the European Central Bank makes any missteps in withdrawing stimulus.
Volatility on Italy’s 10-year bonds leapt to the highest since April 2020 last week after ECB President Christine Lagarde made a half-hearted attempt to push back against markets pricing an interest-rate hike next year. The yield premium over German peers -- a key barometer of risk appetite in the euro zone -- also surged to a one-year high, only to pull back by the most in nine months.
The gyrations shows even the most dovish central banks will struggle to sidestep the market fallout as they telegraph an end to ultra-loose policy. The ECB’s outlook -- it has signaled a very gradual path to higher rates -- leaves it well behind the Bank of England and Federal Reserve, which is about to start tapering purchases this month.
Yet with its pandemic bond-buying program ending in March and investors desperate for clarity on the scope of any future purchases, the market remains on edge. Italian debt has been among the biggest beneficiaries of the ECB’s 1.85 trillion-euro ($2.14 trillion) bond-buying arsenal, driving the yield on 10-year bonds to a record low earlier this year.
“The reality is that we are headed to an end of the pandemic emergency purchase program and a very difficult agreement on what to do with asset purchases thereafter,” said James Athey, investment director at abrdn plc. Italian debt “will increasingly be at the mercy of genuine market forces.”
The Italian-German yield spread tends to be the most sensitive in the region to shifts in risk sentiment and ECB policy given Rome’s huge levels of debt. It has signaled calm for much of this year as the economic recovery in the region picked up and policy makers maintained their support.
Money markets ramped up tightening bets in the aftermath of the ECB’s October policy decision after Lagarde failed to provide sufficient reassurance that borrowing costs would be kept at minus 0.5%, a record low. As much as 23 basis points of rate hikes were expected by the end of next year, before the Reserve Bank of Australia’s Governor Philip Lowe offered a reality check to global bond investors, urging patience on higher borrowing costs.
While the Fed’s meeting saw a reduction in its asset purchases, it stressed patience in raising rates, and the BOE also showed little desire to tighten policy this week. That briefly pushed pricing for the first 10-basis-point ECB rate hike back to 2023, compared with an increase expected in September just a fortnight ago.
The fate of Italy’s yield premium is closely aligned with borrowing costs because the ECB has said it will not raise interest rates until its bond-buying program has ended. The central bank introduced a pandemic plan to run alongside its regular purchases after the coronavirus first struck in March last year, which pushed Italy’s premium above 320 basis points to a 16-month high.
The ECB’s bond buying succeeded in lowering that spread to a six-year low. After it ends in March, the central bank will only buy 20 billion euros of debt per month through a legacy plan, leaving investors waiting for next month’s ECB meeting for an update.
“Central banks are trapped,” said Althea Spinozzi, a fixed-income strategist at Saxo Bank A/S. “Either rate path they decide to walk on will lead to more volatility.”
- Bond sales are expected from Germany, Italy, Netherlands, Portugal and Ireland, totaling 20.5 billion euros according to Commerzbank AG
- Italy will also sell a BTP Futura note to the public
- The U.K. sells 900 million of 10-year inflation-linked notes
- Germany publishes November ZEW figures on Tuesday and the U.K. reveals 3Q growth numbers on Thursday
- A number of central bank speeches are scheduled including from ECB President Christine Lagarde and BOE Governor Andrew Bailey on Tuesday
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