The return of the PIIGS?

The ECB backstop in a rising rate environment

Last week ECB President Christine Lagarde told investors that she could not rule out interest rate hikes this year. Her language was hardly Volcker-era fire and brimstone. Nevertheless, European government bond markets paid attention.

Below are the yields for the 10 year bonds of the old PIIGS countries. The vertical dotted line highlights the meeting.

As we can see, the price action has been pretty dramatic across the board — but especially so in Italy and Greece.

Now, rising interest rates are not in themselves problematic. But recall that the European bond markets were stabilised by an implicit ECB backstop. The word implicit should be highlighted here. The ECB never made the backstop of government bonds official policy. Rather it was communicated with a wink and a nod by Mario Draghi in a 2012 speech.

The actual money standing behind the backstop was deployed through the subsequent quantiative easing programs of the ECB. This highlights an obvious problem: what does the implicit backstop look like in a rising rates environment?

When central banks want to raise the rate of interest, they sell bonds into private markets. Unloading bonds from the central bank balance sheet is how raising interest rates works. Obviously then, raising interest rates is not possible if there is a quantitative easing program in place.

Can the ECB raise rates and maintain the backstop? They have not made clear that they can — but then again, the markets haven’t asked yet because they haven’t thought about it. This will likely change when the ECB actually starts selling bonds.

Will the ECB be able to reassure them that the backstop will remain in place despite the fact that they will be selling bonds? Maybe. But maybe not. More importantly however, the ECB doing this will tear off the fig leaf. The ECB was never really legal and it annoyed the hawkish Germans and their allies to no end. If they come out and say that they are setting price floors on government debt the cat will be out of the bag.

Meanwhile, expect the Germans to claw back power and influence within the Eurosystem. As I wrote about here, the Germans have been warning about inflation for years. It looks to me like they are going to jump all over this and shout “I told you so” as loudly as they possibly can. The hawks will be back on the offensive and the doves will be in retreat.

I cannot predict the outcome of that. But markets should start thinking about this.