European Central Bank tries to assuage fears of debt crisis after bond ‘panic’

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At its regular meeting last week, the ECB confirmed plans to raise interest rates by 25 basis points in July – the first hike in 11 years – to fight inflation and said a larger hike could follow in September if necessary. She also announced that she would stop buying European government bonds.

These plans have greatly increased the cost of borrowing in southern European countries, This led to calls for the central bank to provide more details on how it proposes to avoid fragmentation in the euro zone bond market.

In response to the sharp market sell-off, reviving memories of the region’s debt crisis more than a decade ago, the central bank held a rare, unscheduled meeting on Wednesday. It pledged to use money from maturing bonds it bought under its Pandemic Emergency Purchase Program (PEPP) to ease the strain.

“The Governing Council has decided that it will apply flexibility in reinvesting maturing redemptions into the PEPP portfolio in order to keep the monetary policy transmission mechanism working,” he said in a statement after the extraordinary meeting.

The gap between 10-year German and Italian government bond yields was the widest it had been since March 2020 Earlier this week, according to Tradeweb. The spread between German and Greek bonds has also widened recently.

Italian 10-year bond yields fell slightly after news of the ECB’s emergency meeting, falling to just under 4% from 4.3% on Tuesday, according to Capital Economics.

“The ECB’s carefully communicated strategy was to end asset purchases and then raise rates, starting small and accelerating as needed,” noted Societe Generale strategist Kit Juckes. “This strategy is in all sorts of trouble today.”

At the end of 2021, Greece had the highest debt ratio in Europe at 193%. Next was Italy with 151%.

“Panic in the Periphery”

Europe is in better shape than it was when the ECB last hiked rates in 2011.

The Greek economy in particular has beaten growth expectations and it has favorable terms on its debt that make repayment less worrying. But that’s not the case in Italy, which needs to refinance its debt sooner and where growth has been sluggish.

“Italy has not implemented enough serious reforms,” ​​said Holger Schmieding, chief economist at Berenberg Bank.

And the turbulence in the bond market since last Thursday’s ECB meeting has put the bank under pressure.

“With memories of the European debt crisis still fresh, investors are wondering how and under what circumstances ECB President Christine Lagarde would make good on the promise to … address ‘excessive fragmentation’ if necessary after the end of net purchases,” Schmieding wrote on Wednesday in a note headlined “Panic in the periphery: time for the ECB to show its hand.”

That US Federal Reserve also meets Wednesday to discuss interest rates and is widely expected to raise US interest rates by three-quarters of a percentage point, something it hasn’t done since 1994.

Like the ECB, it faces the major challenge of raising interest rates and rolling back years of stimulus programs without triggering a recession. But only one economy needs to be considered.

“The additional challenge for the ECB is that its policies affect the cost of borrowing in 19 economies with different fundamentals,” commented Schmieding.

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