Following an emergency meeting of its governing council, the European Central Bank on Wednesday said it will bring forward its plans to create a new instrument that will prevent fragmentation between the 19 economies in the eurozone.
The ECB said that the Covid-19 pandemic has “left lasting vulnerabilities in the euro area economy” which now are contributing to an “uneven transmission of the normalisation of our monetary policy” across the different jurisdictions. With that, the ECB alluded to the widerning spreads between government bond yields of weaker and stronger Eurozone countries, notably the difference between Italy and Germany.
“Based on this assessment, the Governing Council decided that it will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate,” the ECB said. “In addition, the Governing Council decided to mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council.
Spreads back down again after ECB statement
The ECB had called the meeting early on Wednesday after the spread between 10-year German Bunds and Italian BTPs widened to a three-year high of 235 basis points. After its announcement, the spread narrowed again and stood at about 215 basis points around 15 CET. That is the same level it was trading at when the ECB met in Amsterdam last week.
Now that the ECB has signalled a bigger commitment to defending spreads, it will likely result in a much narrower Bund-BTP spread on the 10-year instruments. “By doing so, the central bank will clear a path to hike rates quicker and further,” said Simon Harvey, head of FX trading at Money Europe, before the statement was issued. It “will likely enable the euro to trade on a stronger footing through what could be a very turbulent FOMC meeting this evening.”
The ECB announcement also followed a rise in dollar against the euro ahead of the policy meeting of the Federal Reserve later on Wednesday, amid growing expectations that the Fed will raise its interest 75 basis points, although the euro-dollar rate ultimately closed flat on Tuesday. Just last week, the market was expecting a hike of 50 basis points. The ECB announcement triggered a recovery jump in the euro against the dollar. At around 9 am the euro traded 1.049 dollar, compared to 1.042 at the European close on Tuesday.
Comments by Dutch central bank government Klaas Knot in French daily Le Monde on Tuesday also led to movements in the currency markets.
ECB to hike 75bp in September?
“The single currency was buoyed by hawkish commentary from Dutch National Bank President Klaas Knot yesterday,” said Monex’s Harvey. “Writing in the French paper, Le Monde, Knot outlined that if the current inflation environment persisted, the ECB would have to hike rates by more than the signalled 25bps in July, while he also favoured a much more aggressive hike at September’s meeting, alluding to the possibility that the ECB could embark on a 75bp hike. However, the single currency failed to hold onto gains as the dollar went bid across the entire G10 space.”
Widening eurozone spreads reflect market concern over the national debt of some of the weaker Eurozone countries. With a debt of about 160 percent of its GDP, Italy is seen as a major risk to the stability of the eurozone. Spain and Greece also are sources of concern. Although ECB President Christine Lagarde has previously said that the ECB is “not in the business of managing spreads,” the central bank for the eurozone has indicated that it is considering a new mechanism that would make it easier for weaker eurozone countries to absorb the impact of rising interest rates.
(This article will be updated throughout the day on Wednesday.)