European debt: risk before reward

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Good morning. Nice rally in stocks yesterday, for no apparent reason. We’re sticking with the commonsense view that market is going to stay messy until we have a better guess where the Federal Reserve is going to stop, so we’re buckling up for more of this in the coming months. Email us if you have a better idea: [email protected] and [email protected].

Europe’s debt mess

Clearly, we should have written about the European debt proto-crisis last week, but we were too captivated by the Fed to catch up on the situation properly.

While we dithered, the European Central Bank seems to have scared sellers of European peripheral bonds into backing off, buying some time to come up with a structural solution to this problem:

That’s the spread between Italian and German 10-year bonds, which began widening as soon as it became clear that inflation would force the ECB to follow the Fed in raising interest rates. At the right side, you can see how the ECB’s emergency meeting last Wednesday, and the promises of action issued afterwards, reversed the widening, for now.

Recall the basic problem. Italy — which is emblematic of many peripheral eurozone countries from Spain to Greece — has even more debt than it did when it slipped into a crisis 10 years ago. The maths is really nasty now. Italy’s debt is 150 per cent of gross domestic product. Its 10-year bonds, for example, yield 3.7 per cent. Of course it will have sold debt at lower yields than that, but as old debt rolls over, the cost will rise. GDP, on the other hand, is not going to grow at anywhere near 5.5 per cent (3.7 per cent x 150 per cent). So the Italian debt burden is set to grow steadily bigger relative to GDP.

This causes problems. Higher interest rates slow growth in general. Households own quite a lot of the debt, creating negative wealth effects. Banks own a lot too, so as the bonds lose value, their balance sheets weaken and they can’t make as many loans. Then there is the possibility of portfolio contagion bringing other European asset prices down. The debt wobbles could also push the euro even lower, and therefore push the dollar even higher — which is an automatic tightener of financial conditions globally.

This is all quite bad. And then there is the very remote but not unthinkable political follow-on: life within the eurozone becomes so unpleasant for Italians that the country decides to leave the common currency.

The ECB really does not want any of this stuff to happen. Hence its commitment to some kind of bond-buying programme, or “anti-fragmentation instrument”, that would compress Italian (or other peripheral) debt spreads. The details will come next month.

The good news is that the ECB governing council seems to be on the same page, and they are getting after the problem early. As rapid and unsettling as the rise in spreads has been, their absolute level was higher as recently as 2018-19, as the bank’s bond-buying programmes tailed off. Same chart, going further back:

Line chart of Yield difference between Italian and German 10-year bonds showing Now that's a wide spread

The bad news is that the job of depressing the spreads is made complicated by inflation. It is bonkers to buy bonds and raise rates at the same time. In monetary policy terms, the two have opposite effects. So the ECB plan will have to involve some form of “sterilisation” to keep the peripheral purchases neutral to the money supply. Presumably this will mean sales of some other flavour of euro bond, or some sort of term deposit mechanism to sop up the proceeds from the bond purchases (it may also be that anti-fragmentation means that the ECB will have to enact more rate increases than it would have otherwise).

This is all a big experiment. As Eric Lonergan of M&G summed up in Monday’s FT:

Sovereign spread targeting by a central bank has never been done before. The outline of a programme would involve creating a reference basket of “safe” European sovereign bonds from core eurozone countries such as Germany and determining an acceptable spread for each market. The ECB would then commit to enforcing a cap on these spreads . . . 

We need to be clear about the risks. In extremis, the ECB becomes the market-maker for [Italian] or other bonds. Liquidity could disappear. How will Italy issue debt in the primary market, and at what price? Can the arrangements be gamed by market participants? How will the ECB exit?

The ECB is in terra incognita, and if things go wrong, the world economy is going to receive yet another nasty growth shock.

How much money will the ECB spend buying peripheral bonds, and will it be enough? Frederik Ducrozet of Pictet has estimated that €10bn a month could be put to work initially, raised by redemptions of assets bought under the Pandemic Emergency Purchase Programme. But, he points out, twice that amount of Italian debt needs to be rolled over through the rest of this year. Pepp reinvestment “probably falls short of the support needed in case of severe fragmentation and protracted market dislocations”. The ECB may have to go further.

So this could get expensive. But there is the possibility of a significant long-term upside. The original sin of the eurozone is common currency and monetary policy without a central fiscal policy, like the one enjoyed by the US. Anti-fragmentation could be a step in that direction. Here is George Saravelos of Deutsche Bank:

The [proposed anti-fragmentation] tool increases implicit fiscal pooling and establishes a de facto eurobond. A peripheral backstop can theoretically be conceived as a put option on [Italian bonds] and a call option on [German] Bunds thereby creating a more stable GDP-weighted risk-free rate. Assuming the operations are sterilised, the eurosystem will absorb peripheral risk on its balance sheet in exchange for short-dated risk-free liabilities (most likely term deposits) thereby increasing fiscal pooling. An investable [European bond] basket improves European yield. Consider that the Euro-US 10-year interest rate differential is at an eight-year high outside of Covid.

Europe has proven in the past that, under duress, it will do what it takes to hold together its fragile and faulted monetary-financial-political structure. If it does so again this time, it might also end up making some structural improvement.

Given this, it might be tempting to try the Jon Corzine memorial trade, and bet that spreads will compress before you get margin called. Not a stupid bet but, as Corzine discovered, a tricky one to time.

One good read

The champ, at rest.

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