The European Central Bank’s go-slow approach to monetary policy tightening is putting a wall around local bond markets against the turmoil sparked by its US counterpart.
Federal Reserve chair Jerome Powell this week shook equity and bond trading as he opened the door to faster-than-anticipated interest rate rises. It was the death knell for the so-called Fed put, the notion that central bankers would amend monetary policy to halt a severe market decline.
It is a sharp contrast with the ECB, which is not expected to raise rates until the second half of 2023, offering the euro area – and its peripheral bond markets – some degree of protection.
Certainly, European bonds have been caught up in the sell-off and key spreads have widened. Yet when compared to global peers, rates are set to remain lower as the ECB’s dovishness keeps markets in check.
That should mean a weaker euro, something officials might also welcome as a cushion to help the region weather fallout from the Fed and the Bank of England's swift rates rises.
“It is too early to talk about the ECB,” said George Saravelos, global head of currency research at Deutsche Bank. “Yes, European wage growth may rise and the ECB may lift off over the next two years. But the pressure and urgency to do so in Europe is completely different.”
A bond buffer will be welcomed by indebted countries such as Italy and Greece.
ECB president Christine Lagarde knows all too well how easy it is to rock markets, after she sent peripheral yields spiking in early 2020 with a loose remark.
While government debt yields have risen as markets brace for the removal of central bank support, German yields are up this year by only about half the amount compared to US or UK debt.
And German 10-year borrowing costs are still below zero, versus about 1.8 per cent in the US.
That reflects the policy divide, with about five Fed rises priced in for this year. While the ECB will reduce total asset purchases this year, and end its pandemic programme, policymakers have stressed that a 2022 rate rise is unlikely.
Ms Lagarde defended that position this month, one that is expected to be reiterated when ECB officials meet on Thursday.
Recent data, showing weaker euro-area economic confidence and Germany on the brink of a recession, will only reinforce the caution.
To alter the timing, bond buying would have to be wound down faster because the ECB’s guidance is that net purchases will end before rates start to rise. Such a move would have to be flagged well in advance to avoid upsetting the market.
So far, the strategy has worked. The yield differential between Italian and German debt – a harbinger of risk in the region – has widened since October on the ECB’s plans to scale down its bond-buying programmes.
Yet it has stabilised this month and remains well below historic stress levels. A resolution to Italy’s presidential election could mean the spread will tighten.
The Fed-ECB divergence has also driven the euro down to about $1.11 against the dollar, the lowest since mid-2020. Options sentiment remains bearish, suggesting the descent could have farther to go.
While eurozone inflation reached a record 5 per cent last month, policymakers said it will slow this year. The ECB currently forecasts price growth at 1.8 per cent in both 2023 and 2024 – just below its 2 per cent target.
Some are predicting an ECB rates rise as soon as December, and money markets are also toying with that idea. Volatile swap contracts currently suggest around 20 basis points of tightening is priced for the end of 2022. While they may not be an accurate gauge, they do suggest some market participants are hedging for faster normalisation.
“I still think there is a chance the ECB is pulled into a more aggressive stance,” said Brad Bechtel, global head of foreign exchange at Jefferies. “Although we are now open for a move to $1.10, I would be a buyer down there on the back of an eventual shift by ECB.”
For now, that remains a tail risk for later in the year, and there is too much uncertainty for the ECB.