The ECB, Italy and Russia provoke market volatility across Europe

There were three major developments from the European Central Bank, Italy and Russia this week that drove significant intra-day regional financial market volatility, leaving global and regional bond markets with lower yields, somewhat higher risk spreads – especially Italy, and equity markets broadly unchanged. Despite fairly modest realignments in relative valuations, volatility was very high, reflecting the potentially profound, unresolved challenges to European growth and inflation. Following these policy changes and market moves, the volatility continued on 22 July. Bond yields and short-end rates have fallen sharply, reflecting the rising growth risks in Europe.
- The ECB has taken policy rates in one fell swoop back to zero. That was faster than expected just a week ago. The ECB has also planned measures to cap sovereign risk spread and debt stress across government bonds, bank funding and even private corporate credit spreads. These measures should reduce the risk of a financial crisis, unlike the last two lift-offs in ECB rates in 2008 and 2011. However, the risk remains that the ECB is tightening into a significant energy supply shock to contain inflation, pointing to a high risk of stagflation.
- Italian political turbulence continues. Mario Draghi has resigned as Prime Minister, opening the way to snap elections on 25 September. A range of coalition scenarios is conceivable, and it is even possible that a government could be put together in time to approve a budget Draghi must now draft as caretaker PM before the new year – in time and sufficiently credible to maintain EU funding under the Next Generation EU package. But the reforms essential to unlock growth potential seem likely to remain stuck, exposing Italy to further increases in its debt burden, implying continued high volatility in its financial system.
- Russia resumed partial gas supplies – but only to 40% of pre-June levels, while signalling a widening of its war aims in Ukraine to more conquest and control of territory, as annexation of territory already acquired has begun. The combination suggests that the war will continue and that the weaponization of energy will continue to hang over European growth, probably sustaining high commodity prices, especially of oil and gas, and sustaining high inflation.
The net effect is that Europe as a whole is likely to remain a weak link in the global economy and financial markets, with volatility likely to persist in sovereign debt markets – especially Italy. Furthermore, significant downside risks to growth and upside risks to inflation remain given the threat of renewed Russian energy supply cuts, which if anything have only been reinforced by a partial resumption of gas flows.
Following is a series of specific briefings in each of these three areas. At the end, we also include our insights into a topic of concern that’s emerging in the UK — questions regarding the Bank of England’s mandate and operational independence.
1. Eurozone monetary policy
The ECB made a spate of key policy decisions and announcements:
- Rates were raised for the first time since 2011 by 50 basis points (bps) – double the original forward guidance of 25 bps, taking the Main Refinancing Rate to 0.50% and the Deposit Facility Rate to 0.00%. Furthermore, the door was opened to “front-loaded” rate hikes, and a shift to data dependence from forward guidance was emphasized.
- Balance sheet:
- Principal payments from maturing securities in the Asset Purchase Programme (APP – the ECB’s regular-course Quantitative Easing facility) will be reinvested in full for an extended period – at least for as long as the Governing Council deems necessary for ample liquidity conditions. APP holdings and reinvestments are subject to the ECB’s “capital key,” which distributes purchases across countries according to national GDP and population – and hence cannot be used to address country-specific spread deviations that might hamper monetary policy transmission.
- Maturities from the Pandemic Emergency Purchase Program will be reinvested in full until at least the end of 2024, an extension of around nine months to previous forward guidance. Redemptions from the PEPP facility will be reinvested “flexibly” i.e., discretionarily between different issuers with a view to countering risks to policy transmission. At the limit, it appears that any and all repayments could be reinvested in just one country under stress, such as Italy.
- TLTRO III – Targeted Long-Term Refinancing Operations: The ECB will ensure that TLTRO maturities and general bank funding conditions do not interfere with the transmission of monetary policy.
- The new “antifragmentation” tool, now formally designated “Transmission Protection Instrument” (TPI) was also outlined, intended to prevent fragmentation in sovereign debt markets – excessive spread widening in specific countries – that could hinder the transmission of the ECB’s monetary policy changes through financial markets.
If the TPI is used, the scale of bond purchases will depend on the severity of the risks facing policy transmission – and not be limited. Eligible securities for purchase by the TPI are public sector marketable securities with a remaining maturity of 1-10 years. Purchases of private sector securities will also be considered if deemed appropriate. Any purchases under the TPI would be conducted in ways that cause no persistent impact on the overall Eurosystem balance sheet and hence on the monetary policy stance.
Four criteria for TPI eligibility were also announced:
- Compliance with the EU fiscal framework.
- Absence of severe macroeconomic imbalances.
- Fiscal sustainability (trajectory of public debt is sustainable).
- Sound and sustainable macroeconomic policies.
We interpret these changes in monetary policy in a cautiously optimistic manner. There seems to have been a compromise – a stronger than initially signalled rate hike, offset with high flexibility in the reinvestment of PEPP proceeds; limited, specific or new conditionality (conditions are in line with the conditionality for the Next Generation EU Fund package); and wide eligibility for the TPI – somewhat unexpectedly including private securities.
Furthermore, the ECB seems to have decided to do all it can to prevent a resurgence of financial instability as happened in the wake of rate hikes in 2008 and 2011. Then-ECB President Jean-Claude Trichet did reach the ECB’s inflation target, yet the rate hikes needed to control inflation also drove the EZ into financial crisis in 2009/10, only to re-intensify that crisis in 2011-12.
So, the good news is that the risk of financial instability is being reduced because the ECB will address the previous sources of financial contagion, systemic risk and fragmentation. The ECB apparently stands ready to address sovereign debt spreads and hence refinancing risk, the so-called “bank-sovereign doom loop” (due to banks being overexposed to losses in their own sovereigns), and severe downturns that could cause a systemic banking crisis. The combination promises stability for both bank assets (specifically sovereign debt exposures, but potentially also private assets) and for bank liabilities.
That said, the ECB would mop up any reinjection of bank reserves in exchange for troubled assets, or of bank funding from boosting the money supply and inflation risks. Thus, if greater liquidity for banks or sovereigns undercuts the inflation reduction goal of rate hikes and APP/PEPP run-offs, other instruments, such as ECB deposits might be used to “sterilize” or offset liquidity injections.
So far so OK.
But the bad news is that none of these issues can be addressed permanently with ECB liquidity and that market focus is likely to remain on Italy’s ongoing growth challenges and rising debt ratios, especially in the context of the upcoming snap Italian elections and the difficulty of implementing growth-boosting reforms. Secondly, rate hikes are intended to reduce financial system liquidity and money supply growth. Reinvestment of APP and PEPP proceeds would sustain the size of the balance sheet, while their augmentation with the TPI would to some degree undercut the tightening of monetary policy to some degree, even if “sterilized.”
On net, then rate hikes may have to be stronger and longer-lasting in order to cut inflation back down to size – and this together with the likely pressure on European growth from energy price hikes and supply disruptions, suggests that the EZ economy could face serious growth pressures. The ECB might do all it can to cap Italy spreads, but slow or negative growth and political challenges that get in the way of reforms may lead to further increases in Italy’s debt burden.
2. Italian politics
PM Mario Draghi formally tendered his resignation for a second time yesterday; this time it was accepted.
Without getting knee-deep into Italy’s perennially turbulent politics, several key points stand out. Net-net, these factors suggest to us a wide range of potential outcomes in the election.
We expect the markets to focus closely on the composition of the next coalition and the cabinet, to read signals about how effective the new government might be in implementing Draghi’s committed structural reforms. The stronger the reforms, the better the growth prospects, as well as the chances of continued EU fiscal support and the less the need for the ECB to contain Italy spreads.
It has to be acknowledged that Draghi himself was unable to proceed with many critical reforms – competition policy, labor market flexibilization, judicial reform, among many others – just as previous governments were unable to for decades. If these reforms look likely to proceed in the context of a tight budget, hopes for higher growth and a lower debt burden would rise, generating considerable upside. But we would not hold our breath. It seems more likely that Italy will muddle through with a new government in due course after a summer campaign that maintains Italy’s uneasy stability without unlocking much growth potential or financial market upside. We would expect Italy’s risk premiums to remain volatile, though not to explode, given the ECB’s plans to reinvest APP/PEPP purchases and contain sovereign spreads if need be with the TPI.
3. The Russia/Ukraine war and EU energy
Russia increased gas flows to Europe after summer pipeline maintenance – a relief given widespread fear that supply would remain restricted, yet one that is tempered by the fact that the flow of gas has been reportedly restored to only 40% of potential capacity. Furthermore, the Kremlin also signalled a renewed escalation with steps to formally annex territories now under its control in east Ukraine, and Foreign Minister Sergey Lavrov indicated that war aims now extend further into southern Ukraine.
The Russia energy front, then, is also at best mixed news. The worst case of an immediate and full restriction of gas flows has been avoided – for now. Yet the message remains that Russia can dial up or dial down its gas supply to Europe, in the context of its widening war aims in Ukraine and in the face of Western and EU military support for Ukraine and retaliation through sanctions.
Furthermore, Russia’s apparent intent to undercut Western and EU unity may be gaining limited traction. Hungary’s Foreign Minister has met his Russian counterpart Lavrov in Moscow, to ask for an increase in gas supplies, reflecting Hungary’s heavy reliance on imported Russian energy – and perhaps also Hungarian PM Viktor Orban’s relatively strong relationship with Russian President Vladimir Putin. Thus, the uncertainties of further supply-side challenges to European growth and inflation, including stagflation should there be significant shortages/rationing, remain a distinct possibility.
Geopolitically, risks to the Western coalition sustaining Ukraine’s resistance also persist, though it seems unlikely that Putin will be able to directly split core NATO allies such as Germany, Poland, France or the UK – or indeed, Italy, despite its historically strong relations with Moscow.
However, the less successful is the invasion or efforts to split the Western alliance to secure greater leverage over Ukraine, the greater the risk of further cuts to European energy supply and hence the greater the risks for European growth and inflation.
An emerging worry in the UK
UK Foreign Secretary Liz Truss has now repeatedly called into question the Bank of England’s mandate and operational independence. Interestingly, UK Gilts experienced one of the largest rallies in any major developed economy bond market as she did so. Truss seems to be saying that the BoE needs to do something about the UK’s very high inflation, yet is advocating the Bank of Japan’s model – and all while pushing tax cuts and fiscal loosening.
Truss is the emerging favourite to become the new Tory leader, so her plans for the BoE are worth watching, all the more so because they seem to be at cross-purposes to the clear need to get inflation down, and in the context of her plans for tax cuts – as opposed to former Chancellor and key opponent Rishi Sunak’s plans to raise taxes to reduce COVID-related deficits.
The trouble is that Truss’s policy ideas do not add up, in our view. Cutting taxes amid high inflation would, if anything, argue for even tighter monetary policy in order to help get inflation back down to target. Yet, Truss sees the BoJ as a better model than the BoE, even though the BoJ is pursuing continued loose monetary policy to ensure that rising inflation is sustained in perennially deflationary Japan. It’s worth keeping an eye on the UK policy debate and any clarifications about the fiscal and monetary policy mix.
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