The markets are already discounting a rise in interest rates. The ECB itself has announced that interest rates will rise and, more importantly, it will put an end to the massive purchases of public debt in recent years.
This has a direct hit in the bonds of the most indebted countries such as Spain, Italy or Greece. Without the artificial demand from the ECB these countries would have to put more debt on the market, which means that they would have to pay more to investors in exchange for buying all that debt.
As a result of this reality, the risk premium – the spread between the yields of ten-year German bonds and other European bonds – has increased. The German bond this year has begun to trade with positive returns and trades with an IRR of 1.427%.
Back to risk premiums
Price falls in debt markets affect the rise in yields. And those countries with a more deteriorated economic-financial credibility they tend to trade with risk premiums against the safe asset so that investors demand their debt.
And it is at this point that Spain and Portugal, which have reached a risk premium of around 140 points. Italy, which has reached 250 points and Greece, which has touched 300 points.
Some divergence in bond yields is not surprising in a currency union of sovereign states with independent fiscal policiesand can translate into different financing conditions for the real economy.
However, if they rise very sharply and at different maturities, this can cause excessive differences, encouraging fragmentation. Such market moves can stress the debt market, as in 2011-2012, when the eurozone experienced a level of fragmentation that the ECB will want to avoid.
Still, peripheral bond spreads remain far from their 2011-2012 levels and the rise in short-term yields has been relatively contained.
The ECB wants to alleviate the rise in risk premiums
As we have discussed, the ECB plans to end its massive net debt purchases on July 1st. But on Wednesday, the ECB announced its decision to provide greater flexibility to the reinvestment of maturing debt in the “PEPP portfolio” to maintain the function of the monetary policy transmission mechanism, a precondition that the ECB can guarantee to the market. its price stabilization mandate.
Regarding the Pandemic Emergency Purchase Program (PEPP), the Governing Council plans to reinvest principal payments in securities purchased through the program that are due at least through the end of 2024. In any case, the deployment of the PEPP portfolio in the future would be an appropriate position to avoid intervening in monetary policy.
This measure comes in a context in which the ECB’s balance sheet has reached another maximum meanwhile. Total assets increased by €7 billion to €8.82 trillion. The balance of the ECB represents 82.4% of the GDP of the Eurozone, compared to 36.6% of the Federal Reserve.
The renewal of the PEPP can be adjusted flexibly at any time, asset classes and jurisdictions in case pandemic-related markets fragment again. This point is key if there is an assumption of triggered risk premiums.
This could include purchases of bonds issued by Greece, as well as redemption renewals to avoid interruptions in purchases in that jurisdiction, which could affect the transmission of monetary policy to the Greek economy, which is still recovering from the consequences of the pandemic. PEPP purchases can also be reinstated, if necessary, to offset negative shocks related to the pandemic.
After the decision to support the ECB, risk premiums have fallen moderately, although they continue to settle on high ground. The new mechanism will aim to avoid self-fulfilling adverse market dynamics as the ECB tightens policy, but bond yields will still be much higher than in the period since 2015.
This will translate to higher interest payments over time and will reduce fiscal space for eurozone sovereigns. .
An important factor in our sovereign assessment will be how the setting of domestic fiscal policy adjusts to this new environment. Countries that target and achieve fiscal primary surpluses will be more likely to issue debt/GDP
Source: El Blog Salmón by www.elblogsalmon.com.
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