European bond markets have been particularly volatile in recent weeks as the general slide that began late last year deepened. The stagflation shock triggered by the Russian-Ukrainian conflict was a key factor in the deterioration and compounded supply chain restrictions associated with the pandemic. According to the Bloomberg Consensus Forecast, growth forecasts for the Eurozone have fallen to 2.7% in 2022 from 4.4% in September 2021. At the same time, inflation in the euro zone accelerated from 3.5% to 8.6%. This represents an unprecedented deterioration in the macroeconomic outlook.
As a result, the European Central Bank (ECB) came under pressure to tighten monetary policy and stick to its 2% inflation target, despite slowing growth forecasts. In fact, at its last monetary policy meeting, the ECB decided on a “wrong” policy and cut interest rates by 50 basis points (bps) instead of the expected 25 bps. This is the ECB’s first rate hike in more than a decade. Importantly, this move pushed the ECB’s deposit rate out of negative territory for the first time in seven years.
However, tightening monetary policy in the eurozone could prove difficult. The macroeconomic situation differs from country to country within the monetary union, particularly with regard to budgetary needs and debt.
Budgetary positions of euro area countries as a percentage of GDP
(y = government debt inversion; x = five-year average deficit through 2022)
Sources: Haver, IMF, QNB analysis
Southern Mediterranean countries or the “periphery” of the eurozone, such as Greece, Italy and Spain, run larger budget deficits and accumulate higher debt than northern economies (Germany, Austria, Belgium and the Netherlands), which are more fiscally conservative. As a result, southern European economies are more vulnerable to more aggressive ECB tightening as higher interest rates increase debt burdens and potentially create unsustainable sovereign credit dynamics. As further interest rate hikes were priced into the markets, yields in all countries started to rise.
German 10-year Bunds are up more than 130 basis points (bps) since late last year. More importantly, spreads between German Bunds and southern European countries have widened significantly over the same period, approaching stress levels last seen in the depths of the pandemic crisis. The most difficult are Italy and Greece, whose spreads have widened by 130 and 100 basis points respectively. According to various measures of debt sustainability, the current yields of Italy and Greece could well be enough to trigger a new round of discussion about the debt crisis in Europe.
Spreads between 10-year eurozone periphery bonds and German Bunds
Sources: Bloomberg, QNB Analysis
Tighter government bond markets in the “periphery” of the euro have already necessitated action by the ECB. In mid-June, the Governing Council called an emergency meeting to discuss so-called “anti-fragmentation” measures, i.e. policies aimed at helping countries in difficulty and protecting the integrity of the monetary union. In practice, these measures meant that maturing ECB assets could be disproportionately reinvested in bonds of troubled sovereigns and that more funds had to be allocated to provide a safety net for the ‘periphery’. The outcome of these discussions was expressed at the most recent monetary policy meeting, when the ECB announced the establishment of an “anti-spillover instrument” (IPT) to counter “unwarranted market dynamics and chaos”.
For some analysts, these new measures simply reflect the difficulty of normalizing monetary policy in the euro zone. In our view, the emergency meeting laid the groundwork for creating the tools needed to “decouple” ECB action. This means that the general normalization of policies to fight inflation and create price stability will most likely be deployed in the Eurozone through more aggressive rate hikes. On the other hand, to avoid aggravating tensions in the ‘periphery’ countries, the ECB retains discretionary powers to deploy and reallocate the quantitative tools to support the more vulnerable eurozone economies. With that in mind, it is not surprising that the ECB decided to tighten more aggressively.
Overall, we expect the ECB to be more active in the second half of the year. A potential solution to the eurozone’s “macroeconomic divergence problem” opens the door for more aggressive interest rate hikes while preventing more severe shocks and a potential eurozone sovereign debt crisis. We expect the Governing Council to hike rates by 50 basis points at subsequent September and October meetings before returning to a more normal pace of 25 basis points in December. This could just be the beginning of a historical normalization process.
Source: press release
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