Why a weaker euro is the price to pay for another "whatever it takes"
17:06, 15 June 2022
On July 26, 2012, Mario Draghi, then-Governor of the European Central Bank, uttered the fateful words "whatever it takes" to solve the European sovereign debt crisis. At the time, the euro's own existence was at stake, since bond-yield differential (or spreads) between the PIGS (Portugal, Italy, Greece, and Spain) and German Bunds had reached unsustainable levels.
Almost ten years later, the ECB is obliged to patch things up again at an emergency meeting following a week of market turmoil on Italian bonds (BTP). Last week, the ECB's announcement of interest rate hikes beginning in July was enough to spark speculations about the widening of the yield spread between the periphery's most indebted countries and German Bunds.
But, if the ECB truly desires to keep European sovereign bond spreads at bay, a prolonged weakening of the euro (EUR/USD) may be the price to pay.
What is your sentiment on EUR/USD?
ECB steps in amid BTP-Bund spread concerns
ECB emergency meeting: key takeaways
The European Central Bank convened an emergency meeting on June 15 to address renewed fragmentation risks, notably the excessive widening of the spread in yields between Italian and German bonds, which is a key barometer for monitoring financial conditions within the Monetary Union.
The ECB opted to encourage flexibility in reinvesting maturing bonds under the Pandemic Emergency Purchase Programme (PEPP), without giving further details. The PEPP is a scheme designed as a first line of defense to boost the economy during the Covid-19 pandemic. The ECB is also finalising a new anti-fragmentation tool.
The ECB's statement contains a strong and clear message: "the functioning of the monetary policy transmission mechanism is a precondition for the ECB to be able to deliver on its price stability mandate”.
This implies that the ECB aims to ensure that there is no fragmentation in the transmission of monetary policy inside the Eurozone even before considering monetary policy actions under its inflation mandate.
BTP-Bund spread at bay, but what is the price to pay?
The market no longer believes in free lunches these days and carefully considers every step taken by central bankers; recall what happened to the Japanese yen (JPY) as a result of an extremely dovish Bank of Japan.
The spread between the 10-year Italian BTP yield and the German Bund decreased to an intraday low at 2.21% following the ECB's emergency meeting, before rising to 2.27% at the close of today's trading session.
The euro, however, negatively reacted, with the EUR/USD exchange rate trading slightly below the 1.04 mark at 18:30 GMT, ahead of today's Federal Reserve meeting, after reaching an intraday high of 1.05.
The market interpreted the ECB's emergency meeting as a fresh downward catalysts for the euro.
Greater flexibility regarding the reinvestments in the peripheral bonds inevitably implies an ECB ready to respond promptly with new stimulus when spreads widen within the euro area, and this while excluding the extreme scenario of a dissolution of the single currency, on the other hand does nothing but increase monetary policy divergences with the Federal Reserve.
EUR/USD breaks below 1.04
Markets in this article
Related topics