Mirik Chapman is the CEO of Hedge Analytics and a former portfolio manager at Elliott Management and a bond strategist at UBS.
It was fun to eavesdrop on European Central BankApril meeting. Monetary monopoly in the eurozone has probably been even more tense than usual.
On one side of the room are the Germans allergic to inflation and their (relatively) new friends. On the other hand those who freak out at the damage that higher rates will cause to their economies and their debt burden.
In the end, last month’s press conference revealed that the tough family members won by a day. It seems that the ECB will soon follow the Federal Reserve and raise interest rates. Christine Lagard actually said that Last Week. The ECB may even begin to reduce its holdings in government debt at some point.
Apparently the grunts of some of the family members were heard. The grunt has probably increased since then.
Yields on Italian debt soared higher and retirement to 10-year German bonds greatly expanded. In the bond markets there were references to President Lagard’s famous March 2020 claim that the ECB “is not here to close gaps”.
Social media is loaded with commentators metaphorically rubbing their hands in the face of the prospect of another sovereign problem in Europe emerging just as the ECB’s asset acquisition plans end.
Spreads have widened considerably, and this will worsen once the ECB completes QE and starts raising interest rates. Long-term Italian bond yields are now 2 percentage points higher than for 🇩🇪. This fragility will once again put Eurozone policymakers to the test.
Table @RobinBrooksIIF pic.twitter.com/I1RqGyWNkv
– Philip Heimberger (@heimbergecon) May 9, 2022
But is the lesson of the dysfunctional Eurozone family that they always seem to threaten a brawl on the front lawn, and then end up reluctantly embracing and going back in together? There is at least a chance that the result will be again this time.
No one is pretending that rates in Europe are going as high as those in the US. Any change in ECB policy seems like an effort to stop a steep decline in the euro like an attempt to curb inflation. And although rates may rise and ECB asset purchases may end, there are Tricks that can be used if things go awry.
There is the ECB’s expected ‘crisis management tool’, viz According to reports in the works. So far, the details are a well-kept secret. Maybe it would be similar to something like OMT Plan – though I hope without shame.
It is equally possible that the tool will reject the existing asset portfolio. God Emergency purchase plan for the plague (PEPP) has bought almost 1.7 billion euros of government bonds. In contrast to their predecessor Property acquisition plan (APP), the PEPP guidelines are incredibly flexible.
Here are some excerpts from Disclaimer Announces this, with emphasis by FTAV:
For purchases of securities in the public sector, the allocation of benchmark between jurisdictions will continue to be the key capital of national central banks. At the same time, purchases under the new PEPP will be made flexibly. This allows fluctuations in the distribution of purchase flows over time, between types of assets and between areas of jurisdiction.
And from a subsequent statement:
Mutual fund payments from securities acquired under the PEPP will be reinvested at least until the end of 2024. In any case, the future rollover of the PEPP portfolio will be managed to prevent disruption to the appropriate monetary position.
Re-invested securities will probably operate under the same permissive allotment as the original PEPP investments.
Therefore, it is possible that the ECB may raise interest rates and start QT to release asset purchases in some member states (such as Germany) while its reinvestment program continues to buy more securities of vulnerable member states.
It is not often that you see a central bank simultaneously easing and tightening policies. Such flexibility became a hallmark of the ECB that needed to be creative in order to keep the family together.
You can be sure that if an epidemic could be used to introduce such flexible rules, a European war would present an ideal excuse for creativity. As the council said when they Announced PEPP March 2020:
To the extent that some of the imposed restrictions may interfere with the action that the ECB is required to take in order to fulfill its mandate, the Board will consider amending them if necessary to make its action proportionate to the risks we face.
Moreover, if all this fails and peripheral yields continue to rise, there is always a chance that local investors will help save.
When the Italian government’s 10-year yields rose above 4% in 2011, Italian investors enthusiastically bought their debt, even as foreigners sold concerns about Italian fiscal sustainability. When Italian yields fell below 4% in 2014, domestic buying stopped, and Italian investors began buying foreign assets in exchange for higher yields.
It should be noted that Italy’s net international investment position has shifted from a large deficit to a large surplus. With Italian yields rising more than 3% earlier this month, and financial markets everywhere looking risky, it may not be long before local investors start buying Italian bonds again, regardless of ECB policy.
They may be pleased to know that PEPP’s significant reinvestment plan may be persuaded to over – allocate to Italian government bonds if things continue to be challenging.
The ECB’s unappreciated flexibility | Financial Times Source link The ECB’s unappreciated flexibility | Financial Times