The ECB is determined not to be left behind in the fight that the central banks have begun against inflation and in July it will begin to raise rates. It will probably do so with more intensity than expected, especially from September, and this despite the obvious risk of making the cost of financing excessively expensive for the most indebted and vulnerable economies in the euro zone: Spain and, above all, Italy.
The yield on the Italian one-decade bond has climbed this week to 4.1%, with the risk premium at 242, already at the levels of May 2020, when the ECB had already had to activate the anti-pandemic purchase plan after that the Italian country risk reached 280 basis points in March of that year. The Spanish risk premium, now at 135 with the bond at 3.1%, soared that spring over 150.
Christine Lagarde, president of the ECB, assured last Thursday that the institution will not tolerate risk premiums getting out of hand to the point of jeopardizing the effectiveness of its monetary policy. But she did not announce any specific instrument to avoid it, beyond the already planned reinvestment of all the maturing bonds on balance. And it does not seem at the moment that he is going to launch any extraordinary plan. According to Bloomberg, the ECB intends not to reveal its plans to combat the tension in the debt market. At least for now. And he fears that announcing a preventative tool isn’t helpful.
In yesterday’s session, the ECB reiterated its message of not tolerating a disorderly rise in risk premiums, although without revealing its weapons. “We are not going to tolerate changes in financing conditions that go beyond fundamental factors and that threaten the transmission of monetary policy,” said Isabel Schnabel, a member of the ECB Executive Committee during her speech at an event in Paris. And she added that investors “must have a clear understanding” that the ECB “can and should” respond to the spike in risk premiums.
Investors did, however, count on more specificity and Italian and Spanish sovereign debt is beginning to enter a delicate area. For Goldman Sachs, Italy is the exception – strategic due to its status as the third largest economy in the euro zone – to the sustainability of the debt that it does recognize in the rest of the peripheral economies, including Spain.
The US bank warns that the Italian bond is already trading at the level where the debt-to-GDP ratio may enter an upward path if no significant fiscal adjustments are made. The Italian debt already accounts for 150% of the country’s GDP, a percentage that in the case of Spain is 117.7%. For Goldman Sachs, Spanish or Portuguese sovereign debt is still trading at relatively more comfortable levels, but Italian debt has already reached a danger zone. The 7-year bond has shot up to 3.8%, above the 2.75% that the entity considers the advisable limit.
Goldman also points to two other additional risk factors for Italian sovereign debt: the elections that take place next year, with Eurosceptic parties leading the polls, and the dependence on Russian gas, of which Italy remains the second largest buyer in the euro zone, behind Germany. A disruption in supply will be an obvious risk to lower growth.
The average life of the Italian sovereign debt is 7 years, compared to 8.11 for the Spanish. As explained by Nadia Gharbi, Europe economist at Pictet WM, “PEPP program reinvestments will amount to 200,000 million in the next twelve months and there will be 225,000 million in debt repayments from the conventional PSPP program. But only part of it can be redirected to the purchase of peripheral debt, especially Italian”.
For Spain, the rise in the risk premium and the end of the ECB’s net debt purchases is also a challenge, although to a lesser degree than for Italy. In Bank of America they calculate that the ECB will buy 25,000 million euros of Spanish debt per year in its reinvestments, an approximate average of 2,000 million per month. The ECB bought around 120% of the net issuance of Spanish bonds in 2020 and 2021. “This volume could be reduced below 30% this year,” Pictet warns. From Ostrum AM, its global strategist Axel Botte points to an alternative to the ECB. “Spain can also resort to EU loans if market conditions turn unfavorable.”
