Il TPI launched yesterday by BCE did not clarify if, when and how Italy can be economically saved by Bruxelles in time of need. This has led to spreads and BTPs to shoot up rapidly, especially after Draghi resigned and the unknowns about the future of the Bel Paese multiplied. To analyze possible and eventual scenarios on Italy and the Eurozone is Azad Zangana, Senior European Economist and Strategist of Schroders.
The European Central Bank raised interest rates for the first time in 11 years and he did so urgently. Although he reported a 25 basis point hike at the last Governing Council meeting, the ECB opted for a more aggressive 50bps hikebringing the deposit rate to zero, the main refinancing rate to 0.50% and the marginal lending facility rate to 0.75%. The move is historically significant as it ends the era of negative interest rates that began controversially in the summer of 2014. To analyze it all is Azad Zangana, Senior European Economist and Strategist of Schroders.
The ECB said the increase was justified by worrying developments on the inflationary front, including the depreciation of the euro. Inflation hit a new high for the Monetary Union, reaching 8.6% per annum in June.
The ECB also pointed out that, although economic indicators suggest a slowdown in growth, the labor market remains very solid and unemployment at an all-time low. This carries the risk of a rise in wages in response to rising inflation, which could further increase the pressure on prices. A slowdown in demand is therefore justified.
Investors were a little surprised at the magnitude of the rate hike. The consensus forecast had been expecting a 25bp hike, but money markets had priced a 40bp hike, suggesting a 60% chance of a final 50bp hike. It is interesting to note that, despite the more hawkish move, the euro fell from its initial rally against most other currencies, while government bond yields also fellcausing concern.
This could be due to the fact that the ECB effectively canceled its previous promise to raise interest rates by 50 basis points at its September meeting if inflation conditions did not improve. The language change does not rule out another similar, or even greater, rate hike, but it does increase the risk that interest rates may end up exactly where they were previously expected in September.
The more dovish stance for September could be part of the compromise within the Governing Council for a faster rise. The ECB says it will depend on the data that will emerge from meeting to meeting, which could mean that numerous increases are still to be expected. The Bank’s statement also suggested that today’s move does not impact the final level at which interest rates will settle, even though ECB President Christine Lagarde admitted that the committee does not know what the end point will be, namely the “terminal rate”. They just know that interest rates are set to rise again.
One of the constraints on raising interest rates that the ECB will openly discuss is the impact on weaker member states, often referred to as ‘peripheral’. Italy, in particular, was put in the spotlight as investors demanded a lower price (a higher yield), to offset riskier fundamentals, especially after the ECB ended its partial support through QE programs.
At the latest official meeting, the ECB announced its intention to use the expiring assets of the Emergency Pandemic Purchase Program (PEPP) to prevent further spread widening. This was not enough, at the time, to prevent bond vigilantes from driving up Italian yields. The ECB then returned to an emergency meeting on June 15 to design a new anti-fragmentation tool that would integrate the reuse of PEPP assets.
The ECB unveiled the new tool called Transmission Protection Instrument (TPI), which will be used to effectively block the widening of bond spreads. In an effort to discourage legal battles (which will almost certainly follow), one has been added long list of criteria and “safeguards” that are not very transparent and largely meaningless. However, as Lagarde made clear, the ultimate discretion rests with the board of directors.
What matters to investors is that at the moment no limit has been placed on the use of this toolbut on the other hand there is no commitment regarding the size of the fund. From the market reaction it seems investors weren’t impressed. The spread between Italian and German 10-year government bond yields widened after the announcement. It is clear that the ECB hopes that the ICC is similar to the Outright Monetary Operations Program (OMT), a tool that was presented by the previous ECB President, Mario Draghi, in 2012, to help peripheral governments. managed not to use.
Draghi’s role in helping Italy’s debt crisis began more than a decade ago, but it appears to be coming to an end. Investors focused heavily on the ECB’s response following the substantial deterioration of the political situation in Italy.
Italian Prime Minister Mario Draghi has submitted his resignation for the second time in a week, after initially losing the support of the Five Star Movement from the ruling coalition, and then resigning again not having obtained a vote of confidence in Parliament, required by president Mattarella.
The elections were supposed to be held in the spring of next year. The downside to these early elections is that they will likely reduce the government’s time to budget in the fall and therefore significant fiscal and spending changes are unlikely. This could jeopardize Italy’s attempt to satisfy the European Commission to unlock the next tranche of funding from the NextGenEU program.
The latest polls put the Brothers of Italy in the lead, making the party leader Giorgia Meloni the favorite to become the next and female prime minister. However, the right-wing populist nationalist party is sure to clash with the European Union, which worries investors.
In the past, Brothers of Italy had asked for a renegotiation of the eurozone and EU treaties, a position perhaps not as extreme as, for example, that of the “Italexit” party (self-explanatory). However, this is probably not the best direction to take at a time when the EU is offering around 5% of Italy’s GDP in new investment financing and the ECB is heavily subsidizing Italy’s debt.
In conclusion, the BCE should continue to increase i rates of interest at a steady and accelerated rate to reduce the risk of that inflation take root. According to our forecasts, the main refinancing interest rate is expected to reach 1% by the end of the year, but it now appears that a target of 1.5% may be more appropriate. The political upheavals in Italia they will reintroduce market volatility and will certainly test the ECB’s determination as to when (more than if) it will intervene to once again save Italy.