As bond spreads widen, there is little agreement within the ECB as to what levels would constitute market fragmentation.
Internal European Central Bank discussions on how to moderate any future blow-out in peripheral spreads are still at an early stage, with little agreement over how to define a problematic fragmentation of monetary policy transmission even as some national governments begin to fret over rising finance costs, Eurosystem sources told MNI.
The danger of fragmentation is “the elephant in the room” at the ECB, according to one national central bank official, who nonetheless did not expect a potential new tool to address the problem be ready any time soon.
“For us market fragmentation should be in the middle of the conversation. Everyone seems concerned about it and stresses the importance of avoiding it, but we need to explore common ground,” he said. However, he added: “With regards to how market fragmentation is defined, it has a lot to do with who you ask.”
Fragmentation concerns are rising as tighter monetary policy on both sides of the Atlantic widens spreads, with the yield difference between Italian 10-year bonds and benchmark German bunds up to about 190 basis points now from 130 at the beginning of the year. Italian government officials have told MNI higher financing costs are already constraining spending, prompting them to seek additional European support. (See MNI SOURCES: Italy Seeks EU Cover For Borrowing As Yields Rise)
While it is not the ECB’s job to facilitate government borrowing, an excessive divergence between national bond yields would fragment the transmission of monetary policy throughout the eurozone, and President Christine Lagarde said in April that tools to counter this could be designed if necessary. In the meantime, the ECB says it could address any renewed market fragmentation by adjusting the reinvestment of bonds acquired under its Pandemic Emergency Purchase Programme.
Discussions on a possible new anti-fragmentation tool are still at a technical level and have not reached the Governing Council, sources said.
“Until we get closer to a crisis, I don't suppose we will get close to an agreement on details, just that 'we need a tool or system to deal with fragmentation',” said one official, dismissing the idea that any particular spread level could be a trigger point for the ECB.
“Levels...... are not even worth discussing. One man's existential level is another man's arbitrage opportunity. There are certainly no levels being actively considered red lines at the moment and not the remotest chance we could be consensual,” the official said. “For us, it's all about transmission and financing conditions and there are no fixed parameters.”
While national central banks from more vulnerable parts of the eurozone recall the lessons of the extreme fragmentation seen in the 2012 crisis, officials from some countries with sounder finances argue that it is natural for markets to require higher returns from less disciplined borrowers.
Technical work is focussing on the legal design of a bond-purchasing mechanism which would not require the country concerned to have an agreement with the European Stability Mechanism, as is the case with the Outright Monetary Transactions to which Mario Draghi referred in his famous “whatever it takes” speech. Any tool must also meet the requirements of “proportionality” demanded by Germany’s constitutional court.
“There are technical, legal and conceptual problems,” in designing a new tool, said another eurosystem official. “It is something that will take a while.”
FRAGMENTATION HARD TO DEFINE
Fragmentation is challenging to define in a single currency area, the official went on.
“For me it would be a mistake to focus only on measures of spreads fixed at the aggregate level. But at the same time you cannot focus on spread levels of a single country,” the official said.
“Are we talking about spreads with respect to a certain time reference? For example, the spreads that existed before the pandemic? Or are we talking about spreads relative to a fundamental level?” the official said. “The increase in your spread is not bad if it is close to the level that reflects your economic fundamentals.”
Discussions are ongoing, he added, though in his opinion the most appropriate measure would be something close to a weighted average of spreads.
An official from a central bank from a country with a more fiscally austere tradition, though, saw no need for a new anti-fragmentation tool at all at this moment.
“If you look at the whole euro area, different countries have different public debts. It's totally normal that there are different rates,” the official said. “The impression so far is that there's no need for any special measures, tools, instruments.”
An ECB spokesperson declined to comment on the matter.