Investors expect the European Central Bank to accelerate the shrinking of its balance sheet this summer, testing their appetite for eurozone sovereign debt as cash-strapped governments also turn to markets to raise funds.
transfer by ECB Some analysts warned that the tightening of its policy stance is likely to raise the cost of government borrowing in more indebted southern European countries once “investor fatigue” sets in to market more bonds.
This month the ECB began reducing its bond holdings by not replacing the €15bn of securities maturing each month in its asset purchase programme, which makes up two-thirds of the nearly €5tn of assets it buys under its long-standing quantitative policy. Debt markets were volatile after the easing Frankfurt-based institution began reducing its bond holdings this month.
but Eurozone According to Camille de Courcelle, head of strategy for G10 Rates Europe at French bank BNP Paribas, in January and again in February – governments issued about €100bn of additional debt — on top of which maturing bonds were required to refinance. “We have this very strong supply [of new debt] And we think there will be some kind of indigestion in the market and then we’ll see some underperformance,” he said.
Overall borrowing costs for eurozone governments have risen sharply over the past year as the ECB reduced its bond purchases and raised interest rates. But the difference, or spread, between borrowing costs for heavily indebted countries on the periphery of Europe like Italy and safe “core” countries like Germany has narrowed over the past six months.
Since the election of Giorgia Meloni as head of Italy’s right-wing government, she has surprised investors with a relatively cautious approach to public spending, calming concerns about the country’s high debt levels. “Meloni is more financially prudent than initially thought,” said Ludovic Subran, chief economist at German insurance company Allianz.
Italy’s 10-year bond yield was at 4.42 percent on Wednesday, near the highest level in nearly a decade. The spread with its German counterpart, however, is just under 1.8 percentage points – after falling from levels above 2.5 points last year.
This seemed an anomaly to some economists, who expected rising interest rates to widen the spread between riskier assets and less risky assets. “Peripheral stability dissipates in the face of the fastest fiscal tightening cycle on record, and a higher repricing of terminal rates looks misleading,” said Frédéric Ducroset, head of macroeconomic research at Pictet Wealth Management.
However, analysts said higher yields on long-term Italian government bonds were attracting more investors, helping to narrow spreads. Piet Heinz Christiansen, director of fixed-income research at Dunske Bank, said it was “starting to attract a certain type of investor that has been absent for many years in a low interest rate environment”.
For example, Rabobank researchers calculated that asset managers, insurers, pension funds and households “fell in” to absorb €30 billion of Italian sovereign debt sold by banks and foreign investors during last October’s election.
“Italy is one we’re watching fairly closely,” said Michael Metcalf, head of macro strategy at State Street, adding that private sector investor demand for Italian government debt is holding up well.
“Is confidence beginning to falter? We’re not really seeing anything,” Metcalf said. “The [ECB policy] We’ve been well flagged for austerity, so the market has time to adjust. But it’s worth being careful. Quantitative tightening will be a long process.”
But others still think Italy’s debt costs could rise further. Sofia Ortmann, an analyst at DZ Bank, calculated that Italy would need to return to a primary budget surplus — excluding interest costs — to avoid a “vicious cycle” of rising debt and borrowing costs, which has not been done since 2019. The psychological tipping point will also be reached then”, he said, pointing to ratings agencies updating their scores for Italy in April and May as a possible “catalyst”.
Encouraged by the ECB’s smooth start to shrinking its bond portfolio, some members of its governing council, such as Bundesbank President Joachim Nagel, called on the central bank to speed up the quantitative tightening process when it reviews it in July.
Others, such as Austria’s central bank chief Robert Holzmann, have even said it should begin a reduction in a separate 1.7tn portfolio of bonds bought under an emergency scheme launched during the coronavirus pandemic from the end of next year.
To go even faster, the ECB could sell the bonds before they mature, but most analysts think that’s unlikely because it would crystallize big losses.
Constantin Veit, a portfolio manager at bond investor Pimco, said he expected the ECB to stop replacing all maturing bonds in the APP from July, increasing the monthly drawdown of its holdings to €25bn.
“The main consequence is an increase in the supply of government bonds in the market,” Veit said. Generally, he said, such changes “probably don’t matter that much, and higher yields generally make fixed income more attractive”. However, this could change in a political or economic crisis, in which case “the market may take a closer look at supply dynamics.”
Most investors think the private sector has enough capacity to raise an excess supply of bonds this year, but only if inflation declines in line with expectations.
“Last year the ECB helped reduce net bond supply, this year the ECB will add to it, probably taking net bond supply above 700bn euros, up from around 150bn last year,” said Derek Halpenny, head of global market research at MUFG. Significantly more evidence can cause problems.”