A sense of calm that has narrowed the gap between German and Italian debt yields will embolden policymakers next week as they announce principles for so-called quantitative tightening (QT). But whatever they devise under such placid conditions must accommodate the danger of renewed volatility.
“It’s a tricky situation,” said Ute Rosen, a senior derivatives specialist at Union Investment. “The ECB could be thinking that they can risk it with more QT because spreads have tightened so much. The risk is that we could see a situation where it’s too much for the market.”
That’s the challenge for ECB President Christine Lagarde and her colleagues as they unveil a strategy to reduce their balance sheet on December 15 along with an interest-rate increase of at least 50 basis points.
While getting it right will let officials stay focused on bringing a once-in-a-generation inflation shock under control, a market showdown would be a costly diversion.
The moment to act is fortuitous. With the US Federal Reserve hinting at a downshift in aggression, investors are speculating that the global tightening cycle will slow. Uncertainty over the eurozone economic outlook, the path for rates and governments’ borrowing needs may disrupt the calm. The UK’s market turmoil of recent months is instructive on what could then happen.
Aware of the fissile nature of their challenge, ECB officials have already congealed around the idea of running QT in the background to minimise the distraction to investors, and to use rates as their main policy tool.
Most Governing Council members seem to favour what Lagarde describes as a “measured and predictable” approach, rolling off maturing bonds rather than selling them outright.
What’s not clear is whether they’ll want to use caps on the wind-down to be extra cautious.
Bundesbank President Joachim Nagel hinted last week that such measures probably won’t be needed, observing that markets show “sufficient resilience” and “should be able to cope with a passive rolling off.” That theory may be tested before long. Economic uncertainty may be the biggest risk. Sentiment surveys have raised hopes that Europe’s recession this winter may not be too deep, possibly meaning inflation may be high for longer. Meanwhile a turn for the worse could damp demand and price pressures faster than anticipated.
Also unclear is how much more debt governments will have to issue if energy relief needs to be propped up — and how investors will respond. The ECB has warned that excessive support may force additional rate hikes.
Any concerns about debt sustainability risk being complicated by a possible watering down of eurozone fiscal rules that remain suspended in 2023.
Showing how quickly bond markets can seize up was the UK’s recent selloff prompted by expansive tax-cut plans under former Prime Minister Liz Truss, forcing the Bank of England into crisis-fighting mode.
Italy shows the greatest such vulnerability in the eurozone, as newly appointed Prime Minister Giorgia Meloni struggles to contain the fiscally looser demands of her populist coalition. Moody’s Investors Service has warned that public-finance targets may be missed.
The yield gap between 10-year German and Italian bonds — a key gauge of risk — has narrowed to around 190 basis points from a high of over 250 basis points in September.
But much of that reflects traders removing short bets rather than adding long positions that signal confidence. Even without an Italian crisis, investors shouldn’t forget the cascade effect of repricing affecting core markets, according to Jon Levy, senior sovereign analyst at Loomis Sayles.
Goldman Sachs strategists anticipate 10-year German yields will hit 2.75% by the end of the first quarter, an increase of over 90 basis points from current levels.
The ECB’s two-step approach itself may also carry risks, if delaying the details and timing of QT then creates room for market speculation.
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