December 4, 2022

The golden age of low inflation and slowly declining bond yields made many an everyday investor who clung to basic stock market indices look like genius. We’re starting to see what central bankers looked like as superheroes, too.

Bring your thoughts back to July 2012. The eurozone government bond market was in shambles, with Greece at the center and ripples rippling on every other member state deemed fiscally shaky. In general, sober people, not prone to exaggeration, began to question whether the common currency would survive the crisis intact.

Enter Mario Draghi, the then young president of the European Central Bank. During a trip to London, he uttered a now-famous phrase saying that he and the ECB would “do anything” to save the euro.

Those three little words were enough to put out the fire. Sure, the road ahead was bumpy, but the market trusted the former Goldman Sachs banker, who had a way of handling words and having a knack for getting traders and investors to do what he wanted. The moment became the stuff of the monetary policy legend.

Now we are once again concerned about the markets in the eurozone. So far it has been a more low-key affair, fueled ironically by Draghi’s resignation from his next job as prime minister of Italy. In the run-up to his departure, Italian government bonds have been dented, widening the gap between Italian and German benchmark interest rates, and the ECB is concerned about fragmentation.

Hours after he resigned as prime minister, his ECB successor Christine Lagarde made her own big splash: the central bank’s first rate hike in 11 years – a historic jump of half a percentage point – aimed at curbing runaway inflation.

See also  Chinese equity markets plunge as Xi Jinping enters third term as leader

In addition, to tackle fragmentation, she announced the creation of the Transmission Protection Instrument, or TPI, a scheme to help any euro-member state (for which, read: Italy) fend off unwarranted market instability. “The ECB can go big on this,” says Lagarde.

The market’s reaction: a quick thumbs-down. The euro initially jumped. Italian government bonds rose in price. But the more Lagarde talked about how TPI would work, how it was set up, what the eligibility criteria were, and so on, the more those moves were reversed.

“The bond market manipulation plan is ‘we do what we want, when we want,’” was the rather wry assessment of Paul Donovan, chief economist at UBS Global Wealth Management. “The terms are set by the ECB, leaving market manipulation to spin, not objective judgment. The plan adds excitement to the otherwise dull lives of bond traders and creates a treasure hunt to discover the ECB’s intervention levels.”

Lagarde has made some notable missteps in the past, most notably when she indicated early in the Covid crisis that she would not support the bond market, a garbled message for which she quickly apologized.

Now, thanks in part to this plan, it looks like this summer will be marked by further euro weakness and possibly an attack on Italian government bonds. The gap between Italian and German 10-year yields has already widened again to around 2.4 percentage points, painfully close to the perceived danger zone of 2.5.

Line Chart of 10-Year Italian Yield Spread Over German (Percent Points) with Spread Between Italian and German Yields Approaching Observed Danger Zone

At first glance, this is another misstep. But that’s unfair. The staff is not the problem here. Instead, it’s the force shaking markets around the world: inflation.

See also  Bumper profits at banks increase the chance of a windfall for lenders

“There will come a time when the ECB will be tested more seriously,” said Sonja Laud, chief investment officer at LGIM in London. “We need something equivalent to a ‘whatever it takes’ moment. But Draghi only managed to do that in the context of much lower inflation.”

Draghi was able to effectively say ‘trust me, I will throw money and monetary easing on this issue, ask for details later’. Lagarde does not have the same leeway.

Annual inflation barely rose above 0 percent when Draghi cast his spell ten years ago. Now it is 8.6 percent. Lagarde’s job is to bring it down to 2 percent.

In addition, the TPI (not to be confused with the general medical test for syphilis of the same name, nor with TPI Europe – a company that provides “vibration analysis” on machines), comes with corresponding strings. Eligible countries should be able to demonstrate, among other things, fiscal sustainability and sound macroeconomic policies.

That is difficult if Italy no longer has a prime minister. If the market has really taken this on, it’s unclear how quickly TPI can be turned on to help.

“We believe the central bank’s vagueness disappointed market expectations,” said Vasileios Gkionakis, head of G10 currency strategy at Citi. Keep selling euros, he advises.

It all serves to underscore how today’s policymakers are simply unable to bail out the so-called central bank “in the way they have done in the past,” whether that is to soften market tantrums. or to protect countries from stress.

“We took low inflation for granted,” Laud says. “Inflation has changed the story so profoundly. Removing the central bank has changed the markets so profoundly.”

See also  Inside the Range Rover graveyard hidden in the Welsh countryside

[email protected]