Capital Economics: ECB market frustration still possible – What the five options will announce

Her Eleftherias Kourtali

The news that the Governing Council of the ECB is holding an extraordinary meeting today shows that policymakers are taking the threat of increasing the region’s returns more seriously than last Thursday in the regular policy meeting, as Capital Economics points out. Yields on 10-year Italian bonds are falling today from 4.3% at closing yesterday to just under 4.0%. It would be strange if the Bank did not announce anything today, but it seems almost certain that any statement would fall short of a detailed anti-fragmentation tool, as it estimates. Therefore, there is a high probability that the meeting will not be able to stop the expansion of the spreads.

The board has many options, as Capital Economics points out.

First, it is likely to repeat in stronger tones a than it has used so far, that it will not allow further fragmentation of the bond market, perhaps echoing Snabel’s speech last night.

A second possibility is that the ECB will say it will create a specific anti-fragmentation tool in the coming days or weeks, but without giving details – it may announce that work has begun on designing such a “weapon”. This would risk disappointing the markets unless it was credible and seemed to have the strong support of the Council majority. It is worth noting, however, that this is how the OMT program was announced in 2012 – first with an indefinite commitment in August to conduct open market operations, with details coming a month later.

Third, the ECB could allocate an amount of money to be used to address the risk of fragmentation. This could be done without defining the terms and conditions of how it is used and if it is large enough (perhaps 750 billion euros or more) it can have a lasting impact on spreads. However, doubts will remain about whether and when it will be used until the details are clarified.

Fourth, the ECB could change its rules to allow it to reinvest securities within PEPP flexibility to address non-pandemic risks. In itself, this would probably also be frustrating for the market, because the size of the assets that expire is very small compared to the potential need to stabilize markets. The same would likely apply to any other modifications to existing policy tools.

And fifthly, and more effectively, the ECB could announce that it already has a ready-made anti-fragmentation tool that it will start using very soon. Such a tool should be large and flexible. It could allow the ECB to continue purchasing large-scale assets, especially in peripheral countries, while raising short-term interest rates.

“Unfortunately, we doubt that the ECB has such a tool in its drawer as Lagarde said that the Governing Council did not even discuss fragmentation last week. “No further details have been released since the ECB ‘s press conference in April, which left the impression that there is no majority in favor of such a move,” Capital Economics said.

According to the house, the ECB will take some measures when the spread of the 10-year Italian bond reaches about 3.5%. The decision to hold an extraordinary meeting today means that it can do something sooner than that, but it will not be a surprise if the Board is divided on what to do and frustrates the markets, so the spreads are likely to widen further before the The ECB is finally forced to agree on something on a sufficient scale.