Dhe monetary authorities of the European Central Bank (ECB) are holding an extraordinary council meeting this Wednesday to discuss the fallout from the recent sell-off in the bond market. “The Governing Council will hold an ad hoc meeting on Wednesday to discuss current market conditions,” a spokesman for the euro central bank said on Wednesday. According to several insiders, the meeting is scheduled for 11 a.m. However, it is not yet clear whether a message will be published.
Some council members, who were actually expected at an event in Milan this Wednesday, had canceled their trip there because of the council meeting. In the wake of the news, the euro rose 0.7 percent to $1.049. Conversely, the yield on 10-year Italian government bonds fell nearly 30 basis points to 3.874 percent. The Dax increased by up to 1.3 percent to 13,481 points. The sell-off on the stock and bond markets in the previous days was also triggered by the monetary policy meeting of the US Federal Reserve, which will announce its interest rate decision this Wednesday evening.
In view of the high inflation of 8.6 percent in May, economists are now even expecting an interest rate step of 0.75 percentage points, after having previously assumed half a percentage point. Bond yields rose sharply after the ECB announced a series of rate hikes on Thursday. The yield on ten-year government bonds this week exceeded the 4 percent mark for the first time since 2014. The yield difference (spread) between German and Italian government bonds had risen to its highest level in over two years at up to 2.4 percentage points.
The ECB’s response to a bond market panic will depend on the circumstances it is dealing with, Executive Board member Isabel Schnabel said in Paris on Tuesday night. “We have shown in the past that we can adapt flexibly and quickly to the respective circumstances.” According to the German ECB director, a first antidote to curbing the yield gaps is the flexible reinvestment of the funds from expired bonds as part of the trillions bond purchase program PEPP.
Thanks to safeguards in place, the risk of so-called fragmentation — an “unjustified” rise in bond yields for the more indebted members of the euro area — is less likely today than it was a few years ago, said Schnabel, who oversees markets at the ECB. “We expect a strong verbal commitment from the ECB that it will not tolerate fragmentation within the bond markets,” said Ulrike Karstens, economist at DWS, Deutsche Bank’s capital investment company. According to her words, the ECB should expressly focus on making reinvestments more flexible in concrete terms as a first line of defense. This could help calm the market.
Strong commitment to the euro
Despite falling bond prices since the announcement of the ECB’s tightening plans, Schnabel’s comments reflect an emerging consensus in the Governing Council. According to this, a hasty presentation of a new instrument brings hardly any advantages, but exposes the monetary authorities to the risk of being put to the test by the market. Financial service Bloomberg reported in April that the ECB was working on a new tool to be used in the event of a bond failure in weaker euro area countries. So far, the ECB has said it will only use funds from previous asset purchases to address potential problems.
Investors, accustomed to large-scale market interventions by the ECB, are not yet convinced that the central bank can raise borrowing costs while keeping bond yields of the region’s most vulnerable members in check. Schnabel said the ECB would not tolerate “changes in financing conditions that go beyond fundamental factors and threaten monetary policy transmission.”
She pointed to the ECB’s Pandemic Emergency Purchase Scheme, which was flexible and temporary, and the concept of Outright Monetary Transactions as examples of policymakers’ ability to respond to different types of market stress. The latter was put forward by former President Mario Draghi on the premise that he would “do whatever is necessary” to save the euro. There was no volume limit for this, but strict conditions.
According to Schnabel, the ECB can react to new emergencies with existing or new instruments. “These instruments could be different again, with different terms, different durations and different safeguards to keep us firmly within our mandate,” she said of government bonds could be sterilized to contain yield differentials. Then the liquidity created by the purchase would be withdrawn from the market again.
The French council member François Villeroy de Galhau had already made a corresponding statement. For her part, Schnabel said monetary policy “can and should” respond to a disorderly repricing of risk premia. “Our commitment to the euro is our anti-fragmentation tool,” she said. “This commitment knows no bounds. And our track record of stepping in when needed underpins that commitment.”