Investors watch nervously as the ECB cuts its bonds

Investors expect the European Central Bank to accelerate its balance sheet shrinkage this summer, testing their appetite for eurozone sovereign debt as cash-strapped governments also look to the markets to raise funds.

Shift by ECB Some analysts warn that a tightening of their political stance is likely to drive up the cost of government borrowing in the more heavily indebted southern European countries once investor fatigue sets in with more bonds flooding the market.

This month, the ECB began cutting its holdings in bonds without replacing the €15 billion of securities that mature each month as part of its asset purchase programme, representing two-thirds of the nearly €5 trillion in assets it purchased under its long-standing policy of quantitative analysis. easing Debt markets weren’t bothered that the Frankfurt institution began cutting its bonds this month.

But euro area According to Camille de Courcelles, head of strategy at G10 Rates Europe at French bank BNP Paribas, governments issued about 100 billion euros of additional debt – over and above what is needed to refinance maturing bonds – in January and again in February. “We have a very strong stock [of new debt] and we think there will be some indigestion in the market and then we might see some inefficiencies,” she said.

The total cost of borrowing for eurozone governments rose sharply last year as the ECB cut back on bond purchases and raised interest rates. But the difference, or spread, between the cost of borrowing for heavily indebted countries on Europe’s periphery, such as Italy, and safer “core” countries, such as Germany, has narrowed over the past six months.

After Georgia Meloni was elected head of Italy’s right-wing government, she surprised investors with her relatively cautious approach to public spending, calming worries about the country’s high debt levels. “Meloni is more prudent financially than originally thought,” said Ludovic Subran, chief economist at German insurance company Allianz.

Line plot of the spread between German and Italian 10-year bond yields (basis points), showing the contraction in Italy's borrowing costs.

Italy’s 10-year bond yield was 4.42 percent on Wednesday, close to its highest level in almost a decade. However, the German equivalent spread was just under 1.8 percentage points after falling from levels above 2.5 points last year.

To some economists, this seems like an anomaly, who expected that rising interest rates would widen the spread between riskier and less risky assets. “The stability of peripheral spreads in the face of the fastest cycle of monetary tightening and repricing of a higher terminal rate looks puzzling,” said Frédéric Ducrozet, head of macroeconomic research at Pictet Wealth Management.

However, analysts say higher yields on Italy’s long-term government bonds are attracting more investors, helping to narrow spreads. Pete Heins Christiansen, director of fixed income research at Danske Bank, said it has begun to “attract a certain investor base that has been missing for the past many years in a low interest rate environment.”

For example, researchers at Rabobank have calculated that asset managers, insurers, pension funds and households have stepped up to absorb 30 billion euros of Italian public debt sold off by banks and foreign investors during last October’s elections.

“Italy is one country that we follow quite closely,” said Michael Metcalf, head of macroeconomic strategy at State Street, adding that private-sector investor demand for Italy’s public debt has held up well.

“Trust is starting to waver? We don’t really see anything,” Metcalfe said. ” [ECB policy] The tightening we had was well noted, so the markets have had time to adjust. But you should be careful. Quantitative tightening will be a long process.”

But others still believe that Italy’s borrowing costs are likely to continue to rise. Sophia Ortmann, an analyst at DZ Bank, calculated that to avoid a “vicious cycle” of rising debt and borrowing costs, Italy should return to a primary budget surplus – excluding interest spending – which it has not done since 2019. then a psychological tipping point will also be reached,” she said, pointing to ratings agencies updating their assessments for Italy in April and May as a possible “catalyst.”

Encouraged by the smooth start to the ECB’s bond portfolio cuts, some members of its governing board, such as Bundesbank President Joachim Nagel, called on the central bank to speed up the quantitative tightening process when it is considered in July.

Others, such as Austria’s central bank governor Robert Holzmann, have even said they should postpone the start of cutting their standalone portfolio of 1.7 trillion euros in bonds bought under an emergency scheme launched during the coronavirus pandemic from late next year.

To move even faster, the ECB could sell the bonds before they mature, but most analysts believe this is unlikely as it would result in large losses.

Konstantin Veit, portfolio manager at Pimco, a bond investor, said he expects the ECB to stop replacing all APP-maturity bonds from July, pushing its monthly draw down to €25bn.

“The main consequence is an increase in the supply of government bonds in the market,” Veith said. Usually, he says, such a shift “probably doesn’t matter much, and higher returns usually make fixed income more attractive.” However, this may change in the event of a political or economic crisis, in which case “the market may take a closer look at supply dynamics.”

Most investors believe that the private sector has enough room to liquidate additional bond offerings this year, but only if inflation falls roughly in line with expectations.

“Last year the ECB helped cut net bond supply, this year the ECB will add to that, likely bringing net bond supply to more than €700bn, compared to around €150bn last year,” said Derek Halpenny, head of the department. global market research. at MUFG. “If inflation turns out to be noticeably higher than expected, this could create problems.”