European Central Bank tries to ease fears of a debt crisis after bond ‘panic’

The European Central Bank has tried to calm fears of a debt crisis by promising “flexibility” in managing its huge balance sheet and accelerating work on new ways to reduce stress on heavily indebted countries like Italy and Greece as interest rates rise.

At its regular meeting last week, the ECB confirmed plans to increase rates by 25 basis points in July — its first hike in 11 years — to tackle inflation, and said a bigger increase could follow in September if necessary. It also said it would stop buying European government bonds.

Those plans pushed up borrowing costs sharply in countries in southern Europe, leading to calls for the central bank to provide more details on how it proposes to prevent the eurozone bond market from fragmenting.

In response to the sharp market sell-off, which revived memories of the region’s debt crisis more than a decade ago, the central bank held a rare, unscheduled meeting on Wednesday. It promised to deploy money from maturing bonds it bought as part of its Pandemic Emergency Purchase Programme, or PEPP, to mitigate strain.

“The Governing Council decided that it will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism,” it said in a statement after the extraordinary meeting.

The gap between yields on 10-year German and Italian government bonds was at its widest since March 2020earlier this week, according to Tradeweb. The spread between German and Greek bonds has also widened recently.

The yields on 10-year Italian bonds fell back slightly on the news of the emergency ECB meeting, dropping to just below 4% from 4.3% Tuesday, according to Capital Economics.

“The ECB’s carefully-communicated strategy was to end asset purchases, then raise rates, starting in small increments and accelerating if needed,” noted Societe Generale strategist Kit Juckes. “This strategy is in all sorts of trouble today.”

At the end of 2021, Greece had the highest debt-to-GDP ratio in Europe at 193%. Italy was next at 151%.

‘Panic in the periphery’

Europe is in better shape than it was the last time the ECB raised rates in 2011.

Greece’s economy, in particular, has been beating expectations for growth, and it has favorable conditions on its debt that make repayment less of a concern. But that’s not the case in Italy, which will need to refinance its liabilities sooner, and where growth has been dragging.

“Italy has not done enough serious reforms,” said Holger Schmieding, chief economist at Berenberg Bank.

And the turmoil in the bond market since last Thursday’s ECB meeting has piled pressure on the bank.

“With memories of the European debt crisis still fresh, investors are asking how and under what circumstances ECB President Christine Lagarde would deliver on the promise … to act against ‘excessive fragmentation’ if required after the end of net asset purchases,” Schmieding wrote in a note Wednesday headlined “Panic in the periphery: Time for the ECB to show its hand.”

The US Federal Reserve is also meeting Wednesday to discuss interest rates, and is widely expected to raise US rates by three quarters of a percentage point, something it hasn’t done since 1994.

Like the ECB, it faces the huge challenge of trying to raise rates and withdraw years of stimulus without causing a recession. But it only has to take one economy into account.

“The extra challenge for the ECB is that its policies affect borrowing costs in 19 economies with different fundamentals,” commented Schmieding.