Bi-Weekly Asset Allocation – The ECB Problem
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When the Eurozone project began, investors assumed that the credit risk for each country would be shared equally among group members. This notion crumbled after the collapse of Lehman Brothers set off a chain of events that triggered the European sovereign debt crisis in 2010. As shown in the chart below, the average yield on sovereign bonds at 10 years for peripheral and central countries was almost the same since 1998 to 2008. Thereafter, interest rates diverged as investors realized that central governments would not bail out peripheral countries if they encountered difficulties. After Mario Draghi’s “whatever it takes” speech, in which he reassured investors that ECB was prepared to intervene in the markets to prevent yield spreads from widening, bond spreads began to converge. However, the fundamental question of who will insure the credit risk of peripheral countries has never really been addressed.
By buying bonds and expanding its balance sheet, the ECB was able to cap bond yields. Although this measure disproportionately benefits peripheral countries, the action is a form of monetary stimulus, which can increase inflation. Initially, when the ECB implemented its bond-buying program, inflation was well below its 2% target, making its decision relatively risk-free. However, now that inflation has reached 8% for the first time in the history of the euro zone, the continuation of the program could contribute to price pressures. In short, the ECB uses the same tool to tackle two antagonistic problems. As a result, the central bank must choose between containing inflation or allowing financial fragmentation. Nobel Prize-winning economist Jan Tinbergen predicted this dilemma when he postulated that a central bank would need an equal number of policy tools to tackle an equal number of policy problems.
Following the market’s reaction to its decision to tighten monetary policy, which led to a widening of credit spreads, the ECB announced the creation of a new anti-fragmentation tool. The bank is expected to reinvest maturing bonds from its pandemic emergency purchase program back into its balance sheet, but it’s unclear how that mechanism might work. Theoretically, they could use the funds to invest only in peripheral countries, but that would likely anger central European countries like Germany, who would interpret the move as a bailout. Another possibility is that the ECB uses an updated version of Outright Monetary Transactions (UNWTO). The move would allow the central bank to buy vulnerable countries’ bonds in the secondary market provided they meet specific fiscal guidelines, a requirement that could trigger a political backlash in peripheral countries. The central bank is expected to iron out the details of the anti-fragmentation tool at its July 21 meeting.
Although the recent narrowing of the yield spread between Italian and German 10-year bonds suggests that the market is confident that the bank will reach a satisfactory resolution, we remain skeptical. The ECB has an explicit objective of maintaining price stability and an implicit objective of preserving the euro area. Neither choice has a desirable outcome. If he tackles inflation, investors will increase the cost of borrowing for peripheral countries like Italy. Rising borrowing costs could trigger a fiscal crisis and force a government to abandon the euro. On the other hand, if he chooses to keep bond spreads narrow to preserve the euro, he may risk raising inflation expectations along with higher inflation. The most likely outcome of this uncertainty is euro weakness.
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This report was prepared by Confluence Investment Management SARL and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.