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Markets will test the ECB’s resolve


The golden age of low inflation and gently sinking bond yields made many a humdrum investor latching on to basic stock market indices look like a genius. We are starting to see how it made central bankers look like superheroes too.

Cast your mind back to July 2012. The eurozone’s government bond market was in a mess, with Greece at the centre and ripples lapping at any other member state seen as fiscally shaky. Generally sober people, not given to hyperbole, were starting to wonder whether the common currency could survive the crisis intact.

Enter Mario Draghi, the then still new-ish president of the European Central Bank. On a trip to London, he uttered a now famous phrase, saying that he and the ECB would do “whatever it takes” to save the euro.

Those three little words were enough to douse the fire. Sure, the road ahead was bumpy, but the market trusted the former Goldman Sachs banker, who had a certain way with words and a knack for getting traders and investors to do what he wanted. The moment became the stuff of monetary policy legend.

Now, we have worries over the eurozone’s markets once again. So far, it is a more low-key affair, ironically enough sparked by Draghi’s resignation from his next job as prime minister of Italy. The run-up to his departure has dented Italy’s government bonds, widening a gap between Italian and benchmark German yields and causing the ECB to fret about fragmentation.

Hours after he quit as prime minister, his ECB successor Christine Lagarde made her own big splash: the first rise in interest rates by the central bank in 11 years — a historic half-percentage point jump at that — aimed at pulling down runaway inflation.

What’s more, to tackle fragmentation she announced the creation of the Transmission Protection Instrument, or TPI, a scheme to help any euro member state (for which, read: Italy) to fend off unwarranted market instability. “The ECB is capable of going big” on this, says Lagarde.

The market’s reaction: a swift thumbs-down. The euro initially jumped. Italian government bonds picked up in price. But the more Lagarde talked about how TPI would work, how it was put together, what the eligibility criteria were and so on, the more those moves reversed.

“The bond market manipulation plan is ‘we do what we want, when we want’,” was the rather wry assessment by Paul Donovan, chief economist at UBS Global Wealth Management. “Conditions are determined by the ECB, leaving market manipulation down to spin, not objective assessment. The plan adds excitement to the otherwise dull lives of bond traders, creating a treasure hunt to discover ECB intervention levels.”

Lagarde has made some high profile slip-ups in the past, notably when she indicated early in the Covid crisis that she would not support the bond market, a garbled message for which she swiftly apologised.

Now, thanks in part to this plan, it looks like this summer will be marked by even more weakness in the euro and quite possibly also an assault on Italian government bonds. Already, the gap between Italian and German 10-year yields has widened back out to around 2.4 percentage points, painfully close to the perceived danger zone of 2.5.

Line chart of 10-year Italian yield spread over German (percentage points) showing Spread between Italian and German yields nears perceived danger zone

On the face of it, this is another mis-step. But that’s unfair. The personnel is not the problem here. Instead, it’s the force that is shaking up markets around the world: inflation.

“There will come a point where the ECB is tested more seriously,” says Sonja Laud, chief investment officer at LGIM in London. “We will need something equivalent to a ‘whatever it takes’ moment. But Draghi was only able to do that in the context of much lower inflation.”

Draghi was able effectively to say ‘trust me, I will throw money and monetary easing at this problem, ask for details later’. Lagarde does not have the same leeway.

Annual inflation was running barely above 0 per cent when Draghi cast his spell a decade ago. Now it is at 8.6 per cent. Lagarde’s job is to get it back down to 2 per cent.

In addition, the TPI (not to be confused with the common medical test for syphilis of the same name, nor with TPI Europe — a company that provides “vibration analysis” on machinery), comes with strings attached. Eligible countries must be able to demonstrate, among other things, fiscal sustainability and sound macroeconomic policies.

That is tricky when Italy no longer has a prime minister. If the market really did take this on, it is unclear how quickly TPI could be wheeled out to help.

“We believe the central bank’s vagueness disappointed market expectations,” says Vasileios Gkionakis, head of G10 currency strategy at Citi. Keep selling euros, he advises.

It all serves to underscore how today’s policymakers are just not able to ride to the rescue with the so-called central bank ‘put’ in the way they have in the past, whether that is to help soothe market tantrums or to shield countries from stress.

“We took low inflation for granted,” says Laud. “Inflation has changed the narrative so profoundly. Removing the central bank put changes markets so profoundly.”


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