ECB needs a formidable tool against fragmentation

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Safety net: People walking in front of a euro sign in Frankfurt, Germany, as the ECB headquarters can be seen in the background. The challenge facing policy makers is not letting the financing costs of the most indebted euro members soar into non-viable territory. — AFP

JOACHIM Nagel, the head of the German Bundesbank, is sabotaging European Central Bank (ECB) President Christine Lagarde’s plans for a comprehensive safety net to prevent yields of peripheral European countries from blowing out.

In a coruscating address this week, he argued that it’s “virtually impossible” to determine whether a widened spread above benchmark German levels is justified, setting the scene for yet another brutal fight among policy makers that risks sparking a summer of discontent in the bond market.

As surging inflation ends the era of negative rates and quantitative easing in the eurozone, a glaring hole in the bloc’s defences has been revealed.

When Italian 10-year borrowing costs spiked above 4% in mid-June, the ECB was forced to hold an emergency meeting to soothe markets.

Its pledge to “accelerate the completion of the design of a new anti-fragmentation instrument” has worked as a stop-gap; Nagel’s speech, though, suggests nothing is settled yet.

His hardline approach risks leaving economically weaker euro nations, notably Italy and Greece, at the mercy of bond traders if markets start to doubt the ECB’s commitment to counter any sudden spike in sovereign funding costs.

It’s a back-to-the future moment that makes Lagarde’s already difficult job balancing the interests of the 19 countries using the euro that much more strenuous.

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The euro is seriously unimpressed, weakening to a 20-year low against the dollar and close to breaching parity.

For now, the bond market has been more sanguine.

Italian yields are about a percentage-point lower since the ECB’s emergency meeting, but that echoes declines in German and US yields in the same time frame. There’s no room for complacency.

The challenge facing policy makers is not letting the financing costs of the most indebted euro members soar into non-viable territory.

How high is too high? Italy’s central bank governor Ignacio Visco said in mid-June that the spread between Italian and German 10-year debt should be fewer than 150 basis points based on economic fundamentals – and certainly shouldn’t exceed 200 basis points.

The outline of a so-called anti-fragmentation tool, which will be called the Transmission Protection Mechanism, is expected to be unveiled at the next ECB governing council meeting on July 21. But hopes for a “whatever it takes” bazooka to eliminate the threat of unsustainably high Italian or Greek yields look forlorn.

As I wrote last month, a sufficiently potent backstop need never be used.

The best example is the outright monetary transactions programme that former ECB President Mario Draghi heralded in 2012 to get a grip on violent spikes in peripheral nation bond yields, which has not been triggered to this day.