ECB Plans New Tool To Tackle Fragmentation Risk In Eurozone

The European Central Bank said it will be flexible in reinvesting proceeds from the pandemic emergency bonds that are due to mature, and that it will create a new tool to address the fragmentation risk in the euro area after bond yields soared in the past few days, raising concerns of a debt crisis.

The Governing Council held an unscheduled meeting on Wednesday to discuss the current market conditions.

“The pandemic has left lasting vulnerabilities in the euro area economy which are indeed contributing to the uneven transmission of the normalisation of our monetary policy across jurisdictions,” the ECB said in a statement.

“Based on this assessment, the Governing Council decided that it will apply flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate.”

Further, the ECB said the Governing Council decided to mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by policymakers.

Less than a week ago, ECB President Christine Lagarde signaled that the bank was set to raise its key interest rates on July 21. That would be the first such move in 11 years.

The Italian 10-year bond yield have been rising ever since, peaking at 4.2 percent on Tuesday, the highest level since early 2014. The yield eased to around 3.8 percent on Wednesday.

The closely-watched spread between the Italian and German 10-year bonds yields, which reflects the financial stress in the euro currency bloc, eased to around 2.17 percentage points on Wednesday from a peak of 2.42 percentage points on Tuesday.

“The fact that the ECB acted today ahead of a likely 75bp Fed hike is good news,” market strategists at ING said.

“Details on this new facility are still unknown but the mere fact that one is in the works is encouraging news to peripheral bond holders, and will likely slow the selling flow.”

That said, PEPP reinvestments alone would be insufficient to cap sovereign spread widening in a global monetary tightening cycle, and the latest announcement is likely to have only modest implications for the euro, they added.

Capital Economics expects spreads to resume their rising trend soon and to widen significantly further this year.

The research firm also said the flexibility in PEPP reinvestments probably won’t be enough to halt a major sell-off in peripheral bond markets and that ECB policymakers will remain slow to take decisive steps.

“Our best guess is that its plan is to discuss the new fragmentation tool at the scheduled July policy meeting” Capital Economics said.

“We wouldn’t be surprised if, at that point, the Governing Council either fails to reach an agreement or announces only an underwhelming tool with limited firepower.”

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