The hawks on the European Central Bank (ECB) governing council are in the ascendancy — and the bond vigilantes that targeted spendthrift countries during the euro zone debt crisis are on the prowl again.
With euro zone inflation proving stickier than many expected — as recent Covid-19 lockdowns in China compound global manufacturing supply-chain problems and the Russia-Ukraine war fuels food and energy costs — the ECB doves were forced last week to concede to a fairly aggressive path of rate hikes to try and rein in consumer prices.
A 0.25 percentage point hike next month is all but locked in, and a further 0.5 point is on the cards for September — which would move the bank’s deposit rate to zero and key lending rate to 0.75 per cent. Financial markets are now pricing in a total of 1.75 points of rate increases by the end of the year. Only six months ago, ECB president Christine Lagarde was saying it was “very unlikely” that there any rates this year. Still, few would have imagined at the time that euro zone inflation would now be running at more than 8 per cent.
Bond markets, of course, have been ahead of the game. The market interest rate, or yield, on Germany’s 10-year bonds has moved from minus 0.12 per cent at the start of 2022 to an eight-year high of 1.92 per cent this week in anticipation of rate hikes. The yield on similar Irish bonds has spiralled from 0.15 per cent to as high as 2.52 per cent in the same period.
And for the first time in years, investors are taking a more discerning look at the creditworthiness of individual euro zone countries.
The landmark “whatever it takes” to save the euro speech in 2012 from then ECB president Mario Draghi, followed up by a commitment to buy debt of European countries under attack in the markets, and the launch in 2015 of a multi-trillion-euro bond-buying programme, narrowed many of the differences in borrowing costs across euro zone states dramatically. That was before the ECB moved in recent months to wind down net bond buying.
The premium demanded by investors to buy bonds of heavily-indebted countries — compounded by heavy spending during the Covid-19 crisis — has started to blow out again.
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Italy, which already had one of the industrialised world’s highest debt burdens before the Covid-19 pandemic, ended last year with €2.6 trillion of borrowings, the equivalent of 151 per cent of the size of its economy. That’s up from 1.21 per cent a decade ago. Greece’s ratio widened to 193 per cent from 175 per cent over the same period.
A spike in the difference between Italian and German 10-year bond yields to 2.51 percentage points (almost double where they stood six months ago) and widening of the Greek-German spread to 2.95 points spooked the ECB into holding an emergency meeting on Wednesday. It pledged to act against “resurgent fragmentation risks”. This is central bank speak for when the yield spreads between countries become too wide for the ECB to transmit its own rates policy effectively across the euro zone.
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As a stop-gap measure, the ECB signalled it could reinvest money from maturing government debt it bought under a pandemic bond-buying spree into bonds of countries under market pressure. It also promised to come up with a new plan — or what it snappily calls an “anti-fragmentation instrument” — to keep the market wolves at bay.
Whatever it Takes 2.0 seems to have calmed the markets a bit. But the fact that the ECB was not able to outline a concrete programme suggests there is a degree of tension within the governing council. There has to be a real concern that the ECB will end up placing conditions on buying under-fire sovereigns’ bonds that will make it difficult for a government to sign up. This would risk the credibility of the entire exercise.
“We assume any new tool will be enough to avert disaster but not enough to drive spreads significantly lower,” Bank of America economists said in a report on Friday. “There is a lot of resistance to increasing the stock of assets the ECB holds when inflation is so high. The effectiveness of any tool is limited by this. And the risk they fail a few times before finding the right tool is significant.”
Happily, the Irish State managed to escape the PIIGS group (the derogatory crisis-era moniker for Portugal, Ireland, Italy, Greece and Spain) after exiting its international bailout and saw its borrowing costs align to what bond guys call “semi-core” countries such as Belgium, France and Austria.
Still, the spread between Irish and German 10-year bonds has widened from 0.42 percentage points at the end of last year to as high as 0.75 points this week.
The Irish economy may have stood out as a strong spot across western nations in recent years — pushing its debt down to 56 per cent of gross domestic product (GDP) last year from a crisis-era peak of 123 per cent. But the debt ratio relative to the underlying domestic economy stood at almost 106 per cent at the end of 2021 and is forecast to remain at a fairly high 96.5 per cent at the end of this year.
The Government projected in April that it will post a general surplus of €1.18 billion in 2022, following a pandemic-driven €28.5 billion combined deficit over three years.
However, it is locked in talks on a public sector wage deal, with unions pushing to narrow the gap between a planned 1 per cent pay increase in October and soaring inflation, which is forecast to average 6.25 per cent this year. And Taoiseach Micheál Martin committed on Thursday to deal with the general cost of living increases in a “comprehensive” way in the upcoming budget in October. The planned surplus is clearly under threat.
Meanwhile, the State’s growing reliance of late on corporate tax receipts — with company taxes rising almost 30 per cent last year to €15.3 billion — may be exposed in the near term as the global economy slows dramatically.
Global bond investors mightn’t have had much say in the pricing of euro zone debt when the ECB was the main buyer in the market in recent years. But with the big gorilla now in retreat, fund managers will be keeping a closer eye on the State’s finances than at any time since it exited the bailout.
