Comment

The European Central Bank has finally pulled the trigger, raising interest rates for the first time in 11 long years and by a larger-than-expected 50 basis points to zero. The era of negative rates is over and the governing council is likely to fully take the euro zone into positive rates at its next quarterly economic review on Sept. 8. Furthermore, it unveiled an unlimited safety net for peripheral European countries’ bond yields. But it wasn’t enough to convince the market to reduce the spreads on Italian debt, which have soared in recent days. 

It is evident that the half-point rate increase persuaded hawks on the governing council to agree to the new Transmission Protection Instrument, which will allow the central bank to buy unlimited amounts of the bonds of countries when it sees a need to to “counter unwarranted disorderly market dynamics.” The ECB statement makes that link quite clearly, as did ECB President Christine Lagarde in the press conference. But details remain sketchy, and Lagarde counterbalanced her tough talk with the perhaps-too-honest view that the ECB doesn’t want ever to use the new program. Many feel that hawks on the governing council will prevent it ever being brought into action.

The central bank laid out four criteria nations must meet to qualify for assistance under the program: 

• Compliance with the EU fiscal framework: not being subject to an excessive deficit procedure.

• Absence of severe macroeconomic imbalances: not being subject to an excessive imbalance procedure.

• Fiscal sustainability: in ascertaining that the trajectory of public debt is sustainable, the Governing Council will take into account, where available, the debt sustainability analyses by the European Commission, the European Stability Mechanism, the International Monetary Fund and other institutions, together with the ECB’s internal analysis.

• Sound and sustainable macroeconomic policies.

The TPI — which could be nicknamed ‘To Protect Italy’ —  will be unlimited in size and depend in scale on severity of risks. But the euro markets remain unconvinced, seeing this as a shaky compromise. Defining such issues as the sustainability of a country’s debt is a highly contentious issue, something German Bundesbank chief Joachim Nagel highlighted rather pointedly earlier this month.

The collapse of Italian Prime Minister Mario Draghi’s coalition government this week, with national elections now expected in early October, has concentrated the focus even more on the sustainability of more indebted European countries’ borrowing and economic predicament. The 10-year yield spread of Italy over Germany widened by more than 20 basis points on Thursday to over 230 basis points, close to the four-year high reached in June. With Italian 2-year yields reaching 2%, and 3-year yields at 2.5%, the nation is a far cry from the sub-zero funding levels it enjoyed as recently as earlier this year.

With euro zone inflation running at 8.6%, and into double digits in several countries, there really was no time to wait for the ECB. Despite the Italian political turmoil, swift action on curbing inflation is required as there are no signs of a respite in upward price pressure across Europe. “We expect inflation to remain undesirably high for some time,” Lagarde said,

A notable casualty of the about-change in ECB policy is the governing council’s forward guidance, which has been dropped for a more expedient meeting-by-meeting approach. Lagarde twice mentioned the level of euro, which briefly fell below parity with the dollar this month, as creating inflationary pressures. Further weakness in the common currency may have to lead to more aggressive rate hikes.

The disappointing reaction from Italian bond yields to the new crisis plan suggests policy makers will need to spend more time trying to convince traders and investors that they’re serious in recognizing the need to prevent spreads from blowing out. With Italian politics back in a state of turmoil, it’s going to be a long, hot summer for the euro markets. 

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The Strong Dollar Is a Vote of Confidence in the US: Tyler Cowen

• Europe’s Heat Wave Is Bad for Energy Prices, But the Drought Is Worse: Javier Blas

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

More stories like this are available on bloomberg.com/opinion

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