French elections and the European Central Bank

Figure 2. Daily changes in spread on Italian  10-year government bonds over German bunds

While last week’s moves are unnerving, spreads for France and Italy are extremely low by historical standards (Figure 3), so that—unless the bond market sell-off worsen materially—there really is no need for ECB intervention at this stage. That said, narrow spreads are also a source of vulnerability. Italy’s debt-to-GDP ratio is 140%, substantially above that of Germany, which lies around 60%. Rising interest rates increase the risk of having lots of debt, so Italy’s spread should widen as German yields rise. That has not been the case in recent years (Figure 4), raising the risk that spreads could widen sharply if ECB policy toward the periphery changes.

Figure 3. Spread of 10-year sovereign bonds over bunds

Figure 4. 10-year sovereign bond yields, in %

European Central Bank bond market interventions in 2022

In early 2022, the post-COVID inflation shock was peaking. Bond yields were rising everywhere and the consensus at the time was that: (i) inflation was to a material degree demand-led; and (ii) central banks were substantially behind the curve in countering this phenomenon. On June 15, 2022, the ECB surprised markets by holding an extraordinary policy meeting, which set in motion preparations for its new anti-fragmentation tool subsequently named the Transmission Protection Instrument (TPI). It also became clear—with a lag—that the ECB was using proceeds from primarily maturing German government bonds to buy Italian and Spanish debt (Figure 5). This buying was large enough to take Italy off the market, with ECB purchases absorbing all of Italy’s net new debt issuance (Figure 6). The ECB only publishes these data in two-month chunks, so it is impossible to say when buying was concentrated in the June and July two-month window. However, July saw Mario Draghi resign as prime minister, setting the stage for snap elections in September, which brought to power a coalition led by hard-right politician Giorgia Meloni. The parallels with recent events in France are hard to miss, which makes it unlikely that the ECB can stay on the sidelines if the current bond market sell-off worsens materially. Taking no action would be just as political as stepping in to cap spreads.

Figure 5. Monthly European Central Bank net PEPP bond buying

Figure 6. Italy net issuance of BTPs by the central government vs. ECB PEPP and PSPP net purchases, in EUR bn

Eurozone grand bargain needed

The underlying truth is that discretionary bond market interventions are inherently political. After all, if Italy’s yield had been allowed to rise in 2022, perhaps the Draghi coalition would have lasted, buoyed by market volatility and more support for a trusted pair of hands. This is why ECB quantitative easing was constrained by the capital key when it first began in 2015, to prevent discretion in policymaking that might benefit one country over another. The ECB should consider a return to that baseline. This would also go some way to incentivizing fiscal prudence among highly indebted eurozone countries (Figure 7), where it is currently Italy and France—among the most highly indebted countries—who run the widest budget deficits (Figure 8). Such a move will come with more market volatility, but the alternative is that debt reduction never comes back onto the agenda. In the big picture, the eurozone needs a grand bargain, whereby highly indebted countries use wealth taxes to bring down public debt, even as low-debt Northern countries agree to permanent fiscal transfer mechanisms. That will be the starting point for the ultimate goal, which is fiscal union.

Figure 7. General government gross debt, in % GDP

Figure 8. General government deficit, in % GDP