Market Extra: Why the ECB called an emergency meeting as it wrestles with ‘fragmentation’ risk

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It didn’t take long for bond traders to put the European Central Bank to the test, forcing policy makers to hold an emergency meeting Wednesday as they struggled to prevent dislocations in European government bond markets that, if left unchecked, could threaten the viability of the euro itself.

Following the meeting, the ECB announced it would create a new instrument to prevent borrowing costs for the eurozone’s most indebted nations from spiraling to unsustainable levels.

Meanwhile, the central bank said it would use proceeds from expiring bonds it purchased under its former pandemic emergency purchase program, or PEPP, to help keep the yields of those countries. The spread between 10-year Italian BX:TMBMKIT-10Y and German BX:TMBMKDE-10Y bonds narrowed after the announcement.

Bond yields for Italy and other southern European countries had soared relative to German bunds since the ECB last week announced that it would end its quantitative easing program on July 1 and begin lifting interest rates next month. The bond market volatility was widely predicted by economists and market watchers after last week’s ECB decision saw policy makers fail to announce detailed plans for addressing what’s known as fragmentation risk.

Simply put, “fragmentation risk” is the fear that when the ECB tightens or loosens monetary policy, the effects aren’t felt the same way across all 19 nations that make up the eurozone — a potentially destabilizing phenomenon.

It’s a problem that other central banks don’t typically have to worry about. It plagues ECB policy makers because of what economists at Bruegel, the influential, Brussels-based economics think tank, describe as the eurozone’s “peculiar and possibly incomplete institutional framework, with 19 sovereign governments that each have their own fiscal policy but share one currency and one monetary authority.”

While the current situation isn’t nearly as dire as in the past, it stirs memories of the worst days of the eurozone debt crisis a decade ago. Former ECB President Mario Draghi’s July 2012 vow to do “whatever it takes” to preserve the euro at the height of the region’s debt crisis came as fragmentation was stoking fears the shared currency would be blown apart as yields for Italian and other debt-stressed eurozone countries soared toward unsustainable levels.

The eurozone debt crisis calmed in 2012 as Draghi proceeded to lead the ECB in fashioning an emergency bond-buying program that went well beyond anything the central bank had used previously and which could be used in an emergency. The program, known as outright monetary transactions, or OMT, was never used, but its existence, and the work toward fashioning it, helped calm the storm as yields on the debt of the eurozone’s most vulnerable governments returned to sustainable levels.

So what’s the ECB doing now?

Estimates suggest that the reinvestment flows amount to around €15 billion ($15.6 billion) a month, suggesting that €5 billion to €10 billion is available to combat widening spreads, said Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, in a note.

Effectively, that means that rather than reinvesting maturing German bund principal back into Germany’s bond market, the ECB could invest the proceeds in Italian or other so-called peripheral country bonds instead.

“We doubt that this will be enough to stem the selling pressure observed in recent weeks, but it is a start,” he said.

The focus for market participants will be on the new instrument being fashioned by the ECB. A refashioned version of the OMT may be on the table, Vistesen said.

While the OMT remains in the ECB’s toolbox, it isn’t seen as the most appropriate tool to deal with the current situation, economists have said. The OMT was designed to be used in conjunction with the eurozone’s bailout fund to help countries facing solvency crises, which isn’t the case at present.

The Bruegel economists, in a paper, argued that a new option was needed “with the right economic ingredients and a process ensuring that it is politically legitimate and within the bounds set by the European Union Treaties, but that, contrary to OMT, could be applied in real time to neutralize the additional risk that monetary tightening could pose for some countries.”

Vistesen said a modified OMT “would still produce a facility in which a formal request for help from an EZ (eurozone) member country is needed for support
to begin,” while a completely new program is just as likely.

The next question for policy makers would be whether a new facility would expand the balance sheet or whether purchases would be sterilized, he said.

“Time will tell. Still, the ECB is signaling that it is now contemplating the idea that it needs the option to expand its balance sheet — to prevent fragmentation — even as policy rates rise in line with inflation,” he said. “That’s a big step.”

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