ECB must adopt clear spread control framework
Reinvestment flexibility is not a sufficient stabilizing tool against fragmentation risks
The emergency meeting of the ECB today was to be anticipated given the dramatic widening of the Euro Area peripheral government bond spreads in the last couple of weeks. It is interesting to note that while the monetary policy normalization has been rather telegraphed for months. It is the precipitous change in language and tightening that created a violent reaction in bond markets.
If there is one first lesson to be learned is that it is generally bad policy to change a well-choreographed strategy and to abruptly end a framework that took time to develop. The blog by Christine Lagarde on May 26th was an elegant and clear headed description of the way and it was disorienting to see it effectively come to an end as early as the June 9th Governing Council meeting.
The emergency meeting and its conclusion today probably created more questions than answers. First, deciding to convene at this level of spread, the Governing Council has drawn a line in the sand that will undoubtedly be tested despite the announcement of a response in two-steps
First line of defence: Flexibility
First the activation of the reinvestment flexibility for the PEPP programme, which had been discussed. It is striking that the ECB didn’t opt for maximum flexibility by allowing itself to also use flexibly the reinvestment from the PSPP programme.
· The total amount of PEPP redemptions in public bonds is around €200bn in 2022, rising closer to €250bn in 2023. Contrary to the PSPP, the ECB does not publish the monthly profile of PEPP redemptions (only backward-looking numbers in the weekly financial statements) but we can assume a linear path amounting to no more than 20bn per months, which makes for a fairly limited intervention fire-power to tame the markets.
· If the Governing Council decided to activate the flexibility of the PSPP reinvestment, this would add €187bn of PSPP redemptions in the coming 12 months, nearly doubling the firepower.
In all likelihood, the ECB will have to use all the reinvestment flexibility it can and then some. Forcing it to devise and use additional instruments.
Second line of defence: Anti-fragmentation instrument
The second line of defence is to devise a new anti-fragmentation tool as mandated by the Governing Council today and as broadly outlined by Isabel Schabel’s solid speech today. However, the ECB is not a bottom-up organisation, the committees can only deliver if the guidance from the leadership is clear and at the moment it is not.
One critical reason why the committees will struggle is that the definition of fragmentation is not clear. There are several possible ways to define fragmentation and they would each lead to a different set of anti-fragmentation operational frameworks:
The vintage fragmentation definition goes back to Draghi in 2012, which argued that while sovereign spreads were legitimate and necessary, the ECB should respond to redenomination risks. It was hard to define and measure but several empirical methodologies have emerged to decompose spreads in several components that would include that a redenomination risk. The most rigorous approach is perhaps that of the DeSantis (2015), who uses the different between euro and dollar denominated CDS to assess the market pricing of such risks.
But in reality the ECB has now used the term fragmentation to describe a set of circumstances that might be wider than the narrow definition of redenomination. There could therefore be a level of intolerable fragmentation, that may no result from redenomination risk per se. This is potentially an important departure because it would force the ECB to define more clearly what is fragmentation.
There are several competing options:
1. An absolute level of spreads that the ECB would consider excessive and beyond which it would decide to act. To some extent, the ECB may well have signalled on such level by convening its emergency meeting.
2. The second option is to consider that it’s not the absolute of spread but the differentiated widening to a given a shock. Indeed, when the ECB observe a differentiated response to a common symmetric shock, it might decide to intervene so as to ensure that shock doesn’t create divergent impacts across the euro area.
3. The last is to consider that it’s not the absolute level of spread that matters but the speed of widening, the volatility or the derivative of the spread. In this sense, the ECB would only intervene to contain the spread rise irrespective of targeted/fundamental level spread or of whether it creates a divergent impact across the euro area.
These three possible frameworks create widely different operational responses and the market will undoubtedly question under which premise the ECB operates. It is unwise to believe that a vague threat of intervention can put the genie back in the bottle.
In effect, it ECB has now to officially move towards a form of spread control framework and to communicate clearly that framework. Many will argue that this will force the ECB to flirt with monetary financing and expose it yet to another round of litigation before the German Constitutional Court, but this appears largely unavoidable at this stage and will in any case delay and limit the potential for monetary policy normalization/tightening so long as it is not clarified.
Last but not least, while Isabel Schnabel is wrong to argue that the PEPP alone didn’t address fragmentation risks: its effect on spreads was indeed immediate and massive. She is absolutely right however to argue that the ECB will always be fighting against the tide if Euro Area governments do not their part to improve the architecture of the euro area an limit the need for spread control operations by the ECB.
The ECB must own this argument fully and formally call for further fiscal integration in the form of a new round of common borrowing and spending to achieve energy independence and enhance Europe security and defense capacities. It is only by greater fiscal integration that the ECB will be reduce the pressure need for sovereign bond markets interventions.