(Bloomberg Opinion) — The European Central Bank hosted its annual pow-wow this week in the bucolic hills of Sintra, Portugal. There was the usual round of panels with other central bank heads and earnest discussions of economic papers. But instead of debating academic issues, policymakers might have been better off focusing on more immediate issues — such as the recent surge in French yield spreads and the potential for wider bond market contagion.
The 10-year yield premium of French debt to the German benchmark soared to as high as 82 basis points, from a steady level below 50 basis points before the June European Parliament elections. A win for either the hard-left or hard-right at the second round of the French parliamentary elections on Sunday could cause further fixed income ructions. The timing of the plebiscite is bad news for the ECB, which is scheduled to start running down the debt pile accumulated by its pandemic bond-buying program this month. Given the scope for market dislocation, it may want to delay that move.
The Pandemic Emergency Purchase Program was introduced in March 2020, eventually accumulating €1.66 trillion ($1.78 trillion) of euro zone government bonds. It provides the ECB with a flexible and powerful tool; maturing debt from any nation can be recycled back into purchases of the bonds of a different country. So far, repurchases have been over-weighted toward higher-yielding countries like Italy, Spain and Greece, with both Germany and France under-weighted. But there’s no reason why France, in its potential hour of need, couldn’t see that balance tip back into its favor.
At the June 6 ECB quarterly review, the Governing Council confirmed PEPP reinvestments would be reduced by €7.5 billion a month starting in July to a pace of initially just under €10 billion. By the end of the year, the plan is for no maturing holdings to be reinvested. This aggressive time scale could be allowed to slip a little, giving the ECB additional firepower to keep bond spreads in check over the summer if needed. It’s worth noting that the Federal Reserve is paring balance-sheet reduction by about a third; the Bank of England may possibly reduce its active bond sales in September. So there’s no peer pressure if the ECB decides to slow its bond disposals.
The ECB obviously has to be careful with its messaging around such politically sensitive matters as which market it favors. Avoiding concerted intervention is in everyone’s interests but there’s plenty that can be done in a more subtle manner. Firstly, the French central bank can add to the one-fifth of French government bonds it already owns. Secondly, the central bank’s share of large French government bond maturities of €18.7 billion later this month and €35.8 billion in November — which could be worth in excess of €10 billion — can be recycled in full. Reinvestment can happen all along the yield curve out to 30 years; and longer-dated purchases would have bigger market impact. None of this requires any policy changes, or even any declaration of intent; it can just be implemented stealthily.
Judicious application of the PEPP program could prevent having to reach for a bigger bazooka in the future, such as the Transmission Protection Instrument introduced in 2022 as a mechanism for calming unwelcome bond-market moves, but which demands nigh-on impossible conditions before it can be implemented. Realistically, engaging TPI to help France through a politically driven bond-market crisis would fundamentally split the Governing Council in the absence of any existential threat to the euro project. Frugal countries, such as Germany, would object vigorously.
The ECB needs to be mindful of Italian spreads, which are the highest in the euro area at 155 basis points to German levels and have suffered as investors have become nervous of France’s fiscal outlook. The ECB should seriously reconsider scaling back PEPP redemptions, which offer its best defense against a bond-market blowout ruining the summer.
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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