Bloomberg: Traders are preparing for the fall of bonds as the increases approach

Markets are not convinced that the European Central Bank can raise interest rates and at the same time keep the bond yields of the most indebted members of the eurozone under control, according to Bloomberg.

Italy, one of the countries most vulnerable to rising borrowing costs, saw its 10-year debt fall the most since the pandemic as ECB President Christine Lagarde unveiled plans to raise interest rates on Thursday. for more than a decade.

The spread against German bonds, meanwhile, is approaching levels that recently pushed the ECB to start buying government debt in a bid to stabilize the monetary bloc as the Covid-19 swept the continent in March 2020.

The experience from previous explosions of spreads has made traders wary

Investors are worried about the lack of a credible plan to tackle so-called fragmentation – unjustified jumps in borrowing costs of the eurozone’s weakest countries relative to the economically stronger ones. Some say that only a new tool, separate from previous bond-buying programs, can reduce spreads.

“This is a moment of ‘need’ for Lagarde,” said Nicolas Forest, head of candriam’s global fixed income division, a $ 180 billion asset manager. He was referring to a speech by former ECB President Mario Draghi, who pledged to guarantee the integrity of the eurozone at all costs, as the sovereign debt crisis raged in 2012.

Forest is particularly wary of Italian and Spanish debt, given the volatility and the possibility of increased bond issuance by these countries. “The ECB should avoid a policy mistake,” he said.

Central banks around the world are facing a precarious balance as they try to fight rising prices without crushing business. But the situation in the euro area is unique, as it includes 19 divergent economies whose fiscal policies are not aligned.

The fear is that, without a plan, the excessive expansion of margins could divert the ECB from its anti-inflation mission, forcing it to halt – or even begin to reverse – its cycle of interest rate hikes.

What has been done so far to tackle fragmentation – debt reinvestment that is maturing and has accumulated under the ECB’s pandemic asset purchase program – is widely considered inadequate. Programs such as Direct Money Trading, created by Draghi during the last crisis, still exist, but are considered too rigid to be suitable now.

New tool?

A new tool is in the works – as first reported by Bloomberg in April. But the details remain minimal. Some strategic analysts estimate that spreads approaching around 250 basis points could push the ECB to intervene, even if only by presenting the tool.

We are not at these levels yet. The yield on Italian-German bonds is 225 basis points – far from the 500 basis point gap seen in the worst days of Europe’s public debt crisis.

But uncertainty is hitting the euro, which has wiped out its gains after Lagarde offered only vague assurances that “if needed in the future we can plan, we can use the right instrument”.

It is not even clear whether the Council agrees on the need to create a new tool, said Michalis Michailidis, a G-10 fixed-income analyst at Carmignac, who sees markets testing the peripheral spreads further. “Obviously there is no agreement.”

One question many ask is: When will policymakers feel that market movements are driven by speculators rather than fundamentals? Sometimes, however, intervention may be unavoidable.

“The older members of the ECB do not want to discuss a backstop, as they want to put pressure on Italy to reduce its debt,” said Said Haidar, founder of the hedge fund Haidar Capital Management, whose fund, according to Bloomberg, gained more than 10% in April. “But Italy is too big to fail.”

He sees that the ECB is likely to reach a backstop or face the need to suspend its interest rate hikes to ensure Italy’s accession to the euro. That should allow officials to “maybe” raise interest rates to 2% by the end of 2023 from minus 0.5% now, he said.

Even so, investors recognize that the ECB’s communication and credibility are at least as important as the outcome. They will look for clues to future plans when Vice President Luis De Guindos, Executive Board member Isabel Schnabel and Lagarde herself speak next week.

“When Draghi did what he needed to do, when the ECB finally intervened and supported the region, he never actually bought a single bond under the program he announced,” Haidar said. “But it worked. It was like a magic trick.”

Next week

– Traders await the outcome of the Bank of England policy on Thursday, which follows the US Federal Reserve’s interest rate decision a day earlier
– A very large number of scheduled speeches by European Central Bank policy-makers, including Board Member Robert Holzmann, ECB Vice-President Luis De Guindos, ECB Executive Board Member Isabel Schnabel, may provide input to investors. on the forthcoming pace of tightening monetary policy
-Bond sales from Germany, France, Spain, Italy, the Netherlands and Finland