Surprise ECB meeting yields commitment to fight widening bond spreads

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Fresh moves by the European Central Bank to fight widening bond spreads may need to suffice for now, even if analysts and markets were hoping for something more substantial from a surprise meeting on Wednesday.

In a statement, the ECB said it would use authority under an existing program to help tighten widening spreads among periphery countries such as Italy and Spain. It plans to “apply flexibility” in reinvesting redemptions from its Pandemic Emergency Purchase Program portfolio “with a view to preserving the functioning of the monetary policy transmission mechanism.”

The central bank also said it would “accelerate” the development of a new anti-fragmentation instrument.

The announcement of a rare “ad hoc” meeting took investors by surprise earlier Wednesday, sending those European bond yields tumbling on the same day many expect the Federal Reserve will announce a policy decision, with many expecting an interest rate hike of 75 basis points.

Read: In `fragile’ financial markets ahead of Fed’s decision, some traders and strategists see risk of instant recession

Borrowing costs have soared in Europe, notably since the central bank announced at its recent June gathering that its key interest rate would rise 25 basis points in July, and possibly 50 basis points in September. The ECB also said it would end its remaining monthly asset purchases on July 1.

“It’s not exactly a decisive move and did not require a meeting as such,” said Neil Wilson, chief market analyst at Markets.com.

Yet for now, bonds appeared to be falling in line. The yield on Italy’s 10-year government bond TMBMKIT-10Y,
3.762%
fell 34 basis points to 3.813% amid a surge that has taken it from 1.195% at the start of the year. The yield on Spain’s 10-year government bond TMBMKES-10Y,
2.856%
fell 14 basis points to 2.905%.

The yield on Germany’s 10-year bund TMBMKDE-10Y,
1.624%
was down 11 basis points at 1.63%

“Market is going to be a little happier that the ECB is working on this tool but it’s so darn slow and does not appear fully attuned to the risks of further widening of spreads as rising yields reveal the cracks papered over for the last decade by QE and the Draghi effect. Suddenly I don’t feel good about the euro at all….” said Wilson.

The euro EURUSD,
+0.02%
pared gains, last up 0.1% to $1.0434. The common currency has lost 8% so far this year.

The ECB’s announcement fell short of announcing a “fleshed out spread-fighting tool that could provide a permanent solution to the problem,” added Jack Allen-Reynolds, senior Europe economist with Capital Economics.

“Flexible PEPP reinvestments might buy policymakers a little time, but the new ‘anti-fragmentation instrument’ that the Bank is working on will need to go a whole lot further. And there is no guarantee that they reach a consensus on such a tool at the next policy meeting in July, so we could see spreads widen further before a new tool is in place,” he added, in a note to clients.

A day earlier ECB board member Isabel Schnabel said the bank would fight so-called fragmentation in borrowing costs within the bloc that “go beyond fundamental factors and that threaten monetary policy transmission.” The bank has traditionally fought back against peripheral bond yields getting out of alignment with bunds, something that has been dramatically on display since the bank’s June meeting.

Read: ECB failure to address ‘fragmentation’ threat raises risk of steep bond-market selloff say economists

When those persist, “they complicate monetary policy as they drive a wedge between the risk-free rate and national borrowing conditions,” Schnabel said.

“Engineering a soft landing for economies battered by external shocks and facing the highest inflation in decades will be as hard as it sounds for all major central banks. The extra challenge for the ECB is that its policies affect borrowing costs in 19 economies with different fundamentals,” said Holger Schmieding, chief economist and Kallum Pickering, senior economist at Berenberg in a note to clients. ahead of that meeting.

The eurozone is battling nosebleed inflation, due to the fallout from the pandemic and Russia’s unexpected and destabilizing invasion of Ukraine in late February. No end in sight to the biggest war on European soil since WWII has been a particular worry for the already struggling region, as the conflict has driven up energy and other commodity prices.

In May, German inflation surged to its highest level in nearly half a century on higher food and energy prices. The ECB acknowledged those soaring prices at its recent meeting, vowing to ensure inflation returns to its 2% target over the medium. The central bank has forecast annual inflation will rise to 6.8% in 2022, declining to 3.5% in 2023 and 2.1% in 2024 — higher than in the March projections.

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