The ECB will have to decide on the future of its crisis support
Europe’s brightening economic outlook as Covid-19 vaccinations pick up is also accelerating the timetable toward a new danger.
As investors get ready for growth to break out, they’re also preparing for the inevitable consequence: withdrawal of European Central Bank emergency funding. For the region’s most indebted economies — including perennial standout Italy — that would put them face-to-face with market forces they can’t handle. Citigroup Inc. is bracing for a taper of bond buying as early as June, and M&G Investments says it’s time to start shorting peripheral debt.
Because of the ECB’s dramatic measures over the past year, never have borrowing costs in the euro-area been so disconnected from risk. Much of the region is coming off the back of the worst recession since at least World War II, deficits have soared and debt is at eye-watering levels.
Yet an investor lending money to Italy for 10 years can only expect to receive a rate of interest of around 0.75%. Greek bonds, considered a junk asset by all three of the major credit ratings agencies, come with a rate of less than 1%. A decade ago, the euro-area debt crisis pushed its yields above 40%.
“You only get temporary elimination of credit risk in European sovereigns when you’re in an emergency,” said Eric Lonergan, a money manager at M&G. “The problem is when you come out of emergency, you’re back to market forces in your bond market and some of these numbers look really, really bad. Europe is ironically vulnerable to recovery.”
The rally in euro-area debt is mostly down to the ECB’s 1.85 trillion-euro ($2.2 trillion) pandemic bond purchase program, and it’s helped to line investor pockets. Over the past year alone, Italian bondholders have made returns of more than 10%, according to Bloomberg Barclays Indices. Over a decade, they would have nearly doubled their money.
“The country is able to refinance debt at much lower yields because of the ECB, so the crisis has been somewhat of a blessing in disguise for Italy,” according to Hendrik Tuch, head of fixed income NL at Aegon Asset Management. “Low Italian sovereign bond yields and spreads are not made in Rome but in Brussels and Frankfurt, which is the main issue for the longer-term outlook on Italian sovereign bonds.”
While ECB President Christine Lagarde said this week that it would be “premature” to talk about easing support, the debate about what to do and when could be fast approaching. Some policy makers are ready to argue at the June meeting that the pandemic emergency purchase program should start being scaled back in the third quarter, Bloomberg reported Friday, citing officials familiar with internal deliberations.
Despite Lagarde’s reassuring words, such talk will heighten investor focus on the day of reckoning. Without emergency support, the focus will return to debt in Greece, Italy and Spain, which ballooned further in 2020 due to necessary health and crisis spending, and whether it can ever be brought under control.
At PGIM Fixed Income, which manages about $968 billion, head of global bonds Robert Tipp is keeping the tilt toward peripheral bonds he’s had since the sovereign debt crisis, but is also starting to worry about the post-taper outlook.
“The risk is how fraught is the process of going from this heavy stimulus environment back to one of fiscal rectitude,” he said. “The fundamentals are lousy for some of these countries.”
Stretched finances leave euro-area periphery in peril
Source: Eurostat, European Commission
For now, European Union member states are preparing to spend money from the bloc’s recovery fund, due to start disbursing cash around the middle of the year. Italian Prime Minister Mario Draghi, the former ECB president credited with saving the euro during the last debt crisis, is planning to reengineer Italy’s economy with more than 200 billion euros of funds.
But while this stimulus will help the recovery, the question is whether it will generate sustained growth strong enough to meaningfully chip away at Italy’s enormous debt pile, currently around 160% of economic output. Fitch Ratings warned this month that Greece’s debt-to-GDP ratio would stay above 200% this year and any failure to reduce it could lead to a negative rating action.
Another key question is when the EU might re-impose fiscal rules — which were suspended during the pandemic — and what form they will take. While the fiscal situation in some countries has to be tackled, overly strict targets, for example on deficits, could do more damage than good by sucking life out of economies.
Saxo Bank A/S is one of the biggest doomsayers on Europe’s periphery, warning that there could be a sovereign debt crisis part 2, beginning with a exodus of foreign investors from Greek debt, where they own 90%. Saxo’s concern is that with U.S. bond yields 60 basis points higher than at the start of the year — and with the currency hedging equation increasingly favorable — investors would prefer to put money there rather than in higher-yielding European sovereigns.
For the ECB, the unwinding dilemma will once again see it grappling with the inherent challenge of the euro area: setting monetary policy for 19 countries with vastly different economic, inflation, unemployment and debt situations. If it begins to tighten, the peripheral nations will be the ones that lose out, making their huge deficits harder to finance.
“It’s very difficult to see something anything other than fiscal austerity,” said M&G’s Lonergan. “I don’t know when it will strike but I think you’re getting very, very good odds if you look at a lot of the more vulnerable parts of the European bond market now.”