Analysis | The ECB Needs a Formidable Tool Against Fragmentation

For now, the bond market has been more sanguine. Italian yields are about a percentage-point lower since the ECB’s emergency meeting, but that echoes declines in German and US yields in the same time frame. There’s no room for complacency.

The challenge facing policy makers is not letting the financing costs of the most indebted euro members soar into non-viable territory. How high is too high? Italy’s central bank Governor Ignacio Visco said in mid-June that the spread between Italian and German 10-year debt should be fewer than 150 basis points based on economic fundamentals — and certainly shouldn’t exceed 200 basis points.

The outline of a so-called anti-fragmentation tool, which will be called the Transmission Protection Mechanism, is expected to be unveiled at the next ECB governing council meeting on July 21. But hopes for a “whatever it takes” bazooka to eliminate the threat of unsustainably high Italian or Greek yields look forlorn. As I wrote last month, a sufficiently potent backstop need never be used. The best example is the Outright Monetary Transactions program that former ECB President Mario Draghi heralded in 2012 to get a grip on violent spikes in peripheral nation bond yields, which has not been triggered to this day.

French central bank head Francois Villeroy De Galhau remains optimistic, telling Les Echos that “it is probable that the existence alone of this instrument allowing fast and massive intervention if needed is sufficient, without needing to activate it.” The scale of the program will be key; as Olivier Blanchard, the former chief economist of the International Monetary Fund, said on Twitter on Wednesday, size matters.

For the head of the German central bank to question the concept of capping yields is genuinely unhelpful. The history of the ECB is littered with challenges in the German constitutional court, and indeed resignations of Bundesbank members. The illegality of cross-subsidization remains an obstacle, with richer northern European states wary of bailing out their highly indebted southern neighbors. It’s an inherent flaw in the construct of the euro, an economic and monetary union without interwoven fiscal or banking pacts.

It won’t reassure Germany that French finance minister Bruno Le Maire said said in a Financial Times interview this week that EU debt rules are “obsolete” and should be rethought. Former Italian Premier Enrico Letta warned earlier this week about the need for euro unity. “The response has to be common,” he said. “The risk is that leaders turn a blind eye until it’s too late.”

It’s bad enough that the central bank has left it so late to address the risk of fragmentation. If Nagel gets his way, the program could end up neutered and ineffective. So far the ECB has trailed deploying an already existing flexibility, reinvesting its existing portfolio as bonds mature so that, for example, the proceeds of a redeemed German bond could be spent on Italian debt. For the pandemic emergency purchase program, this amounts to about 10 billion euros ($10.4 billion) per month, far below its regular monthly purchases of 40 billion euros earlier this year, although extending it to the full asset purchase program would boost that firepower. Still, if market stresses occur when redemption monies are insufficient to hold back the tide, bond traders will smell blood.

The irony for Germany and other hawkish ECB members is that, as the bond markets are swiftly pricing in, the less credible the bond support mechanism turns out to be, the fewer interest-rate hikes will be possible. To successfully curb consumer prices after years of wanton stimulus, the ECB needs to increase borrowing costs, but it cannot do that if the unity of the euro zone is at stake. Rate hikes and combating inflation, or fiddling while Rome burns? Your call, Germany.

More From Bloomberg Opinion:

• The German Trade Deficit Is Not a Cause for Alarm: Tyler Cowen

• Late Start on Inflation Traps Powell in Dilemma: Jonathan Levin

• The ECB Needs Positive Rates Sooner Rather Than Later: Marcus Ashworth

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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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