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The writer is group chief economist at Société Générale
Long bond yields in the Eurozone have risen sharply on the back of the “whatever it takes” fiscal measures presented by Germany’s chancellor-in-waiting, Friedrich Merz, on March 4. The benchmark 10-year Bund yield has jumped by about 0.25 percentage points since then.
The sell-off is warranted by fundamentals, given expectations for significantly stronger economic growth and government bond issuance. This is not true elsewhere in the region, where similar scaled debt-financed spending measures are not in the pipeline.
The welcome German measures won final approval last Friday, with relatively low import content from other euro area member states. As such, positive spillover from stronger German growth to the rest of the region is likely to be modest and is potentially even in danger of being more than offset by the sharp rise in bond yields. Soaring bond yields also add to governments’ debt servicing costs, adding to the challenges for member states in need of fiscal consolidation.
It is further worth noting that euro area bond yields are now around the levels that prevailed last June, just before the European Central Bank embarked upon its current monetary policy-easing cycle, which has now led to 1.50 percentage points of cuts to its key deposit rate. There is thus an argument to be made that euro area member states, outside Germany, are experiencing an “unwarranted” increase in bond yields. Zooming in on the major 10-year benchmark bond yields in the France, Italy and Spain, these have increased by about 0.25 percentage points since the announcement of the German measures.
The ECB’s toolkit has since the euro area debt crisis been expanded to deal primarily with unwarranted widening of euro sovereign bond yields relative to the German benchmarks, with notably the Outright Monetary Transactions and the Transmission Protection Instruments schemes. Neither tool has been used, but there is little doubt about their effectiveness.
OMT is the 2012 scheme to buy government bonds in potentially unlimited amounts if needed. It was the delivery on Mario Draghi’s July 2012 promise to do “whatever it takes” to preserve the euro as the then-ECB president. TPI, introduced in July 2022 in what Christine Lagarde, his successor, called a “historic moment”, marked a further addition to counter disorderly market dynamics. It allows the ECB to buy the bonds of a Eurozone country if is suffering from an increase in its borrowing costs beyond the level justified by economic fundamentals.
In theory, the TPI could be activated to counter the recent rise in bond yields in member states outside Germany, but this seems both unlikely and suboptimal. The TPI is widely understood to be a tool to counter disorderly spread movements in jurisdictions under market pressure and comes with the conditionality of respecting European fiscal rules. Using the tool outside this context may lead to market confusion.
And further rate cuts could prove a blunt instrument, if such moves were to merely to steepen the German bond yield curve, widening the gap between shorter and longer interest rates. Likewise if rate cuts steepened the yield curve farther by raising growth and inflation expectations in Germany.
There is thus a case to be made for a tool to deal with an unwarranted rise in long euro area bond yields that is driven by the de facto anchor for this market, Bunds.
Pausing so-called quantitative tightening — the unwinding of the long-running programme of bond buying to lower the costs of borrowing in order to stimulate the economy — could mark a first step. That could ease upside pressures on the premiums placed on longer-term bonds across the euro area over short-term debt.
A speech by ECB executive board member Piero Cipollone last month discussed the right balance for the ECB’s balance sheet and its implications for monetary policy. He cited survey data suggesting the potential for a greater impact from QT on Spain and Italy, compared with France and Germany, in lifting bond yields. If accurate, this asymmetry offers a case to pause QT.
A further avenue for the ECB involves its Pandemic Emergency Purchase Programme, a temporary asset purchase programme of private and public sector securities buying to offset the shock of the outbreak of Covid-19 in 2020. The ECB is letting those purchases “run off”, not reinvesting proceeds from maturing bonds. The central bank has said this process will be managed “to avoid interference with the appropriate monetary stance”. It may be time to consider that, at least pausing PEPP run-off outside Germany.
