# How will the ECB contain fragmentation risk in euro area bond markets?
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2022-06-14
Category: INVESTING
Category URL: https://financedigest.com/category/investing
Meta Title: ECB Bond Market Strains: Will Rates Rise?
Meta Description: As ECB moves to exit stimulus, bond spreads widen in weaker EU countries like Italy, Spain, Portugal. Will ECB act to contain fragmentation risks?
URL: https://financedigest.com/how-will-the-ecb-contain-fragmentation-risk-in-euro-area-bond-marketshtml

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By Yoruk Bahceli, Dhara Ranasinghe and Stefano Rebaudo

LONDON (Reuters) – As the European Central Bank rushes to exit stimulus and raise interest rates to tame inflation, bond markets are testing its ability and willingness to act against the strains that are starting to hit weaker countries in the bloc.

The premia investors demand to hold bonds from Italy, Spain and Portugal relative to safer German debt — spreads in market parlance — have risen to the highest since 2020.

With [ECB key rates](https://www.financedigest.com/fed-rates-up-boe-up-ecb-up-stocks-up.html "Fed rates up, BoE up, ECB up, stocks up") seen rising by 75 basis points within the next three months, Italian and Spanish 10-year borrowing costs have hit eight-year highs.

So far the ECB says it sees no need for new tools to help these weaker, highly indebted economies cope with [higher interest rates](https://www.financedigest.com/wall-st-indexes-mixed-treasury-yields-tick-up-as-higher-rates-loom.html "Wall St indexes mixed, Treasury yields tick up as higher rates loom"). But the spread widening has left investors wondering when the ECB might step in to contain so-called fragmentation risks and what it could do.

There is no easy fix,” said Frederik Ducrozet, head of macroeconomic research at Pictet [Wealth Management](https://www.financedigest.com/wealth-management-consultant.html "Wealth management consultant"). “We are here today because of the lack of decision in the past six months.”

Here are some options for the ECB:

1/ DO NOTHING

With [inflation at record](https://www.financedigest.com/inflation-drives-britains-record-christmas-grocery-sales.html "Inflation drives Britain’s record Christmas grocery sales") highs, this appears to be the current stance.

The 10-year Italian/German yield spread is at 250 bps, which [markets previously viewed as an ECB](https://www.financedigest.com/instant-view-ecb-sticks-with-big-rate-hike-even-as-bank-fears-roil-markets.html "Instant View: ECB sticks with big rate hike even as bank fears roil markets") pain threshold.

But sources told Reuters after last Thursday’s [ECB meeting](https://www.financedigest.com/sterling-steadies-vs-dollar-ahead-of-boe-ecb-meetings.html "Sterling steadies vs dollar ahead of BoE, ECB meetings") that policymakers did not think current conditions amounted to “fragmentation” and there was no debate around a new programme.

The very fact that the topic was not even [approached in any shape or form just told the market](https://www.financedigest.com/uk-property-market-braced-for-influx-of-chinese-buyers-as-golden-week-approaches.html "UK property market braced for influx of Chinese buyers as Golden Week approaches") that the pain threshold is a lot further away than what we thought previously,” UBS strategist Rohan Khanna said.

Graphic: What is the [ECB’s pain threshold on the Italy/German bond](https://www.financedigest.com/ecb-can-cut-carbon-footprint-by-shedding-bonds-of-biggest-polluters.html "ECB can cut carbon footprint by shedding bonds of biggest polluters") spread? – https://fingfx.thomsonreuters.com/gfx/mkt/znpnegdlqvl/IT1406.PNG

![](https://www.globalbankingandfinance.com/wp-content/uploads/2022/06/146.jpg)

2/ BE SMART

The only tool the ECB has laid out so far is channelling reinvestments from maturing [bonds bought for pandemic-era stimulus back into the markets](https://www.financedigest.com/stocks-up-bond-yields-fall-as-markets-mull-a-fed-policy-pause.html "Stocks up, bond yields fall as markets mull a Fed policy pause") experiencing stress.

But as spreads widened in April and May it did not gear reinvestments towards southern [European debt](https://www.financedigest.com/european-junk-debt-sales-spring-back-to-life-as-sentiment-improves.html "European junk debt sales spring back to life as sentiment improves").

Societe Generale estimates that over the coming year, the [ECB will receive 300 billion euros](https://www.financedigest.com/euro-zone-consumers-more-optimistic-on-inflation-ecb-survey-shows.html "Euro zone consumers more optimistic on inflation, ECB survey shows") ($314 bln) from redemptions from its emergency PEPP scheme. But it does not see that as containing spread-widening.

Even if the ECB reinvests the entire flow from German and French bonds into Italy — around 12 billion euros per month — that will be less than the ECB’s net purchases in Italy of almost 14 billion euros monthly [since March](https://www.financedigest.com/the-nasdaq-100-on-track-to-have-its-best-week-since-march-2010.html "The Nasdaq 100 On Track to Have its Best Week Since March 2010") 2020, SocGen added.

Graphic: [ECB net](https://www.financedigest.com/ecb-weighs-bigger-rate-hike-with-safety-net-for-indebted-countries.html "ECB weighs bigger rate hike with safety net for indebted countries") purchases of bonds under PEPP – https://fingfx.thomsonreuters.com/gfx/mkt/byvrjaonave/YBCHART1406.PNG

![](https://www.globalbankingandfinance.com/wp-content/uploads/2022/06/144.jpg)

3/ REMEMBER SMP, OMT?

The ECB does have other tools at hand, including the Outright Monetary Transactions (OMT) scheme, an unused crisis-time tool allowing for unlimited purchases of a country’s debt.

But economists doubt it will be deployed as it requires countries to [sign up for a European Union](https://www.financedigest.com/french-unions-unanimously-sign-wage-agreement-with-edf-company-says.html "French unions unanimously sign wage agreement with EDF, company says") bailout which usually contains unpopular conditions.

Others say the [Securities Markets](https://www.financedigest.com/demand-for-secure-and-safer-home-environment-will-increased-revenue-sales-of-baby-gates-market.html "Demand For Secure And Safer Home Environment Will Increased Revenue Sales Of Baby Gates Market") Programme (SMP) is more likely to be revived. This facility would enable the [ECB to buy bonds without adding to stimulus already sloshing around](https://www.financedigest.com/no-messing-around-with-red-hot-inflation-five-questions-for-the-ecb.html "No messing around with red-hot inflation: Five questions for the ECB") the system.

4/ [BRING BACK](https://www.financedigest.com/trump-charges-bring-new-york-zombie-case-back-to-life.html "Trump charges bring New York ‘zombie case’ back to life") QE

If rapid spread widening raises [financial stability risks](https://www.financedigest.com/theresa-may-brexit-and-risk-and-safe-assets-a-snapshot-of-global-financial-markets.html "Theresa May, Brexit and risk and safe assets: A snapshot of global financial markets") for the bloc, the ECB could just resume asset purchases. But given it has just ended bond-buying, that move seems unlikely.

Note, however, that on March 18, when the COVID-19 outbreak sent Italian/German [bond spreads briefly above 300 bps, the Bank of Italy stepped up bond purchases on behalf of the ECB](https://www.financedigest.com/ecb-could-slow-rate-hikes-but-bond-run-off-should-start-soon-knot-says.html "ECB could slow rate hikes, but bond run-off should start soon, Knot says").

Later that day, the ECB launched its PEPP emergency scheme, [calming markets](https://www.financedigest.com/stocks-claw-back-as-markets-calm-after-evergrande-led-slide.html "Stocks claw back as markets calm after Evergrande-led slide").

The obvious one would be (restarting) APP (Asset Purchase Programme) but it’s difficult to do when you are [hiking rates,”](https://www.financedigest.com/hopes-of-slowdown-in-rate-hikes-bolster-shares-ahead-of-u-s-gdp.html "Hopes of slowdown in rate hikes bolster shares ahead of U.S. GDP") said State Street’s head of EMEA macro strategy Timothy Graf.

Graphic: [ECB asset purchases are ending](https://www.financedigest.com/analysis-investors-stick-to-bets-on-early-end-to-ecb-hikes-as-uncertainty-grows.html "Analysis-Investors stick to bets on early end to ECB hikes as uncertainty grows") soon – https://fingfx.thomsonreuters.com/gfx/mkt/xmvjowgykpr/ECB1406.PNG

![](https://www.globalbankingandfinance.com/wp-content/uploads/2022/06/145.jpg)

5/ SOMETHING NEW

Perhaps that’s why talk of a new tool has gained ground, something allowing the ECB to target bond-buying specifically at weaker states, deviating from the usual principle of purchasing assets relative to the size of an economy.

However, such [flexibility or deviating from the so-called “capital key”](https://www.financedigest.com/insights-on-the-flexible-packaging-global-market-to-2027-key-driving-factors-and-challenges.html "Insights on the Flexible Packaging Global Market to 2027 – Key Driving Factors and Challenges") could prove a sticking point, especially from Germany’s constitutional court.

The ECB “knows that whatever they come up with, they might end up in the German constitutional court,” said Andrew Mulliner, [head of global](https://www.financedigest.com/hybrid-theory-promotes-ines-martins-to-global-head-of-product-names-sean-badlishah-managing-director-of-apac-region.html "HYBRID THEORY PROMOTES INÊS MARTINS TO GLOBAL HEAD OF PRODUCT; NAMES SEAN BADLISHAH MANAGING DIRECTOR OF APAC REGION.") aggregate strategies at Janus Henderson.

Graphic: [Fighting inflation](https://www.financedigest.com/inflation-fighting-central-bankers-air-climate-role-doubts.html "Inflation fighting central bankers air climate role doubts") ECB’s number one priority – https://fingfx.thomsonreuters.com/gfx/mkt/jnvweogrkvw/inflation1406.PNG

![](https://www.globalbankingandfinance.com/wp-content/uploads/2022/06/147.jpg)

(Reporting by Yoruk Bahceli in Amsterdam, Dhara Ranasinghe in [London and Stefano Rebaudo in Milan; additional reporting by Sujata Rao; Editing by Sujata Rao and Susan Fenton)](https://www.financedigest.com/london-fears-losing-luxury-shoppers-to-paris-and-milan.html "London fears losing luxury shoppers to Paris and Milan")


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