The markets will test the determination of the ECB
The heyday of low inflation and slightly declining bond yields has made many monotonous investors who cling to basic stock indexes look like a genius. We’re starting to see how this made central bankers look like superheroes too.
Think back to July 2012. The eurozone government bond market was in trouble, with Greece at the center and ripples hitting any other member state considered fiscally fragile. People who were generally sober and not prone to hyperbole were beginning to wonder if the single currency could survive the crisis intact.
Enter Mario Draghi, then still new 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 put out the fire. Sure, the road ahead was bumpy, but the market trusted the former Goldman Sachs banker, who had a certain sense of words and a knack for getting traders and investors to do what he wanted. The moment has become the stuff of monetary policy legend.
Now we have concerns again in the Eurozone markets. So far it’s been a more low-key affair, ironically triggered by Draghi’s resignation from his next post as Italian prime minister. The build-up to his departure has dented Italian government bonds, widening the spread between Italian and German benchmark yields and causing the ECB to worry about fragmentation.
Hours after leaving the post of Prime Minister, his successor at the ECB, Christine Lagarde, caused a stir: the first interest rate hike by the central bank in 11 years – a historic jump of half a point percentage – aimed at reducing runaway inflation.
Additionally, to combat fragmentation, she announced the creation of the Transmission Protection Instrument, or TPI, a program to help any eurozone member state (for which, read: Italy) combat instability unjustified market. “The ECB is capable of going big” on this, says Lagarde.
The market reaction: a quick boost. The euro initially jumped. Italian government bonds appreciated. But the more Lagarde talked about the functioning of the TPI, the way it was put together, the eligibility criteria, etc., the more these movements were reversed.
“The bond market manipulation plan is ‘we do what we want, when we want,'” was the rather tongue-in-cheek assessment of Paul Donovan, chief economist at UBS Global Wealth Management. “Conditions are determined by the ECB, leaving market manipulation to run, not objective assessment. The plan adds excitement to the otherwise dull life of bond traders, creating a treasure hunt to discover levels of intervention of the ECB.
Lagarde has made some high-profile slip-ups in the past, including when she indicated at the start of the Covid crisis that she would not support the bond market, a garbled message for which she quickly apologized.
Now, thanks in part to this plan, it looks like this summer will see even more euro weakness and most likely an assault on Italian government bonds as well. Already, the spread between Italian and German 10-year yields has widened to around 2.4 percentage points, painfully close to the perceived danger zone of 2.5.
At first glance, this is another misstep. But it’s unfair. The staff is not the problem here. Instead, it is the force that is shaking markets around the world: inflation.
“There will come a time when the ECB will be tested more seriously,” says Sonja Laud, chief investment officer at LGIM in London. “We’ll need something equivalent at some point ‘whatever it takes’. But Draghi was only able to do so against the backdrop of much lower inflation.
Draghi was effectively able to say “trust me, I will throw money and monetary easing at this issue, ask for details later”. Lagarde does not have the same leeway.
Annual inflation was barely above 0% when Draghi cast his spell ten years ago. It is now 8.6%. Lagarde’s job is to bring it down to 2%.
Additionally, 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 testing” on the machines), comes with strings attached. Eligible countries must be able to demonstrate, among other things, fiscal sustainability and sound macroeconomic policies.
It’s tricky when Italy no longer has a prime minister. If the market really supported this, it’s unclear how quickly TPI could be deployed to help.
“We believe the central bank’s vagueness disappointed market expectations,” said Vasileios Gkionakis, head of G10 currency strategy at Citi. Keep selling euros, he advises.
All of this serves to underscore how today’s policymakers are simply not able to come to the rescue with the so-called central bank “mis” as they have done in the past, whether to help ease market crises or to shield countries from stress. .
“We took low inflation for granted,” Laud says. “Inflation changed the narrative so profoundly. The removal of the central bank shook the markets so profoundly.