Europe’s Bond Traders Grow Wary of ECB Desire to Keep Powder Dry

Christine Lagarde Photographer: Thierry Monasse/Pool/Bloomberg
Christine Lagarde Photographer: Thierry Monasse/Pool/Bloomberg

(Bloomberg) -- Europe’s bond markets are becoming wary that the European Central Bank may just be easing off the gas.

Yields from Germany to Italy rose after President Christine Lagarde emphasized that the central bank’s entire 1.85-trillion-euro pandemic stimulus package may not be needed, should financing conditions in the euro area remain favorable. While Lagarde also said the program could “equally” be recalibrated, the concern for investors is whether the message translates into a slower pace of purchases from the biggest buyer of debt in the region.

It’s a phenomenon Goldman Sachs Group Inc. has called “peak ECB,” now that the bulk of the institution’s firepower to combat the coronavirus’ economic damage is possibly in the rear-view mirror. Such a stance would align with that of other major central banks, from the U.S. to Japan, that have signaled there is enough money currently in the system to support the recovery. And with European governments willing and able to embark on fiscal spending like never before, the conditions are ripe for higher yields.

“This is a tapering story,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc, off the back of the ECB decision. “Yields have to rise as this risk premium gets priced in.”

Spreads Checked

German 10-year bonds fell Thursday. Yields rose as much as four basis points to -0.49%, a one-week high. Similar-dated Italian rates hit 0.71%, the highest since Nov. 12, while the euro increased as much as 0.6% to $1.2173.

Lagarde’s comments on Thursday came after people familiar with the matter said the ECB was buying bonds to limit the gap in borrowing costs between the region’s strongest and weakest economies. The central bank has specific ideas on what spreads are appropriate, according to one of the people.

That policy had kept a lid on the yields of the euro area’s most indebted nations, like Italy, whose borrowing needs ballooned in the pandemic. The influence of the ECB’s buying power over markets was seen this month, when Italian yields only briefly spiked on the risk of fresh elections.

Less Support?

But with a Brexit deal secured, vaccines being rolled out, and a landmark European Union fiscal package in the offing, the need for the ECB to continue offering as much support may be diminishing.

It’s a realization that echoes among traders across the world. Ten-year Treasury yields could nearly double to 2% by the end of this year, according to JPMorgan Asset Management, which expects the Federal Reserve to flag a tapering of purchases by year-end. Bank of Canada Governor Tiff Macklem said the economy was flush with stimulus, while the Bank of Japan sees a rebound starting in April.

The outlook for inflation, which has long been absent from the euro area, remains the key question. Five-year, five-year inflation swaps, a gauge of expectations for price rises over the next decade, have steadily climbed from their nadir in March 2020 to around 1.33% -- well below the ECB’s target of just below 2%. Euro strength, which could damp import costs, adds a further complication.

‘Hawkish Trap’

While Lagarde said the central bank need not use up its full bond-purchase envelope, she also stressed that “nothing is off the table.”

It’s possible that traders could push Europe’s bond yields even higher and test the ECB’s approach to retaining some of its firepower, according to Antoine Bouvet, senior rates strategist at ING Groep NV.

“It’s a nice hawkish trap the ECB is setting up for itself,” Bouvet said. “If they want to spend less, they need to announce that they will spend a lot. Otherwise the market will doubt and test their resolve.”