(Bloomberg Opinion) — The European Central Bank hosted its annual pow-wow this week in the bucolic hills of Sintra, Portugal. There was the usual round of panels with other central bank chiefs and in-depth discussions on economic papers. But rather than debating academic issues, it may be better for policymakers to focus on more immediate issues – such as the recent surge in French yield spreads and the possibility of broader bond market contagion.
The 10-year yield premium on French debt over the German benchmark rose to 82 basis points, from a stable level below 50 basis points ahead of June’s European Parliament elections. A victory for the hard-left or the hard-right in the second round of French parliamentary elections on Sunday could lead to further cuts in fixed income. The timing of the referendum is bad news for the ECB, which is due to begin reducing debt accumulated by its pandemic bond-buying program this month. Given the scope for dislocation in the market, it may want to delay the move.
The Pandemic Emergency Purchase Program was launched in March 2020, ultimately accumulating €1.66 trillion ($1.78 trillion) of euro zone government bonds. This provides the ECB with a flexible and powerful tool; Maturing debt from any country can be recycled back into the purchase of another country’s bonds. So far, buybacks have been weighted more toward high-yield countries like Italy, Spain and Greece, with less weight given to both Germany and France. But there is no reason why France, in its probable hour of need, could not see that balance swing back in its favor.
At the ECB’s quarterly review on 6 June, the Governing Council confirmed that PEPP reinvestment would be reduced by €7.5 billion per month starting in July, initially at a pace of less than €10 billion. As of year end, the plan is not to reinvest any mature holdings. This aggressive time scale could be allowed to be reduced slightly, giving the ECB additional firepower to keep bond spreads under control over the summer if needed. It’s worth noting that the Federal Reserve is cutting its balance-sheet by about a third; The Bank of England may possibly reduce its active bond sales in September. So there is no peer pressure if the ECB decides to slow down its bond disposals.
The ECB clearly needs to be careful with its messaging regarding such politically sensitive matters as to which market it favors. It is in everyone’s interest to avoid concrete interventions but there is much that can be done in a more subtle way. First, the French central bank could add a fifth of the French government bonds it already holds. Secondly, the central bank’s stake in large French government bond maturities of €18.7 billion at the end of this month and €35.8 billion in November – which could be worth more than €10 billion – could be fully recycled. Reinvestment can occur over a period of up to 30 years along the entire yield curve; And long-term buying will have a big impact on the market. None of this requires any policy change or declaration of intent; It can simply be implemented silently.
Judicious application of the PEPP program could prevent a big bazooka in the future, just as the Transmission Protection Instrument was introduced in 2022 as a mechanism to quell unwanted bond-market moves, but not before. That it demands impossible circumstances to be implemented. Realistically, involving the TPI to help France through a politically motivated bond-market crisis would fundamentally split the Governing Council in the absence of any existential threat to the euro project. Frugal countries like Germany will strongly oppose this.
The ECB needs to be mindful of Italian spreads, which are the highest in the euro zone at 155 basis points over German levels and have suffered losses as investors become jittery over France’s fiscal outlook. The ECB should seriously reconsider reducing PEPP redemptions, which provide the best hedge against the bond-market shocks that could ruin the summer.
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Prior to this, he was Chief Market Strategist at Haitong Securities in London.
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