Europe’s Coming Bond Avalanche Will Test the ECB


European governments are set to issue bonds to the market this year. Investors will require further increases in yields or a significant improvement in the region’s inflation outlook to absorb the incoming supply wave, adding to the monetary policy challenges facing the European Central Bank.

The 10 largest eurozone countries are expected to sell 1.3 trillion euros ($1.38 trillion) worth of bonds this year. More than half of that will be new money after the debt matures. That’s a huge jump in net new supply to 340 billion euros, according to analysts at NatWest Group Plc. The ECB’s quantitative tightening process, which will start in March, will add to the pressure and will need to absorb at least 150 billion euros into the bond market this year.

Someone, somewhere will have to buy all these new securities. Unfortunately, the timing is poor for the world’s central banks to become net sellers of the stocks they hoarded after the global financial crisis to finance pandemic response measures.

Austria, Slovenia, Ireland and Portugal all started syndicated new episodes this week, with France and Italy likely to follow. It will be a busy month as sovereign borrowers will want to start their issuance calendars. Germany’s annual inflation slowed to 9.6% in December from a peak of 10.4% in October, which is an unexpected boon. A fall in French consumer prices. Eurozone inflation is still a long way from the ECB’s 2% target, but the road back to price normality has to start somewhere. An improvement in inflationary conditions is likely to push investors up to full European debt levels. Otherwise, yields will continue to rise to attract sufficient demand, which risks tightening the bounds of EU cohesion.

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The largest additional net borrower will be Germany, which has dramatically changed its financing methods. 300-350 billion euros of bonds will be sold this year, about half of which will be new money. This is close to tripling last year’s net demand. The country’s Economic Stabilization Fund has determined that around 200 billion euros are needed to deal with the recession caused by the massive drop in energy prices following Russia’s invasion of Ukraine.

Germany is the benchmark for European government bond markets, so a sudden surge in supply is an even bigger problem for the bloc. As bond yields rise to attract investors, debt costs will rise in countries with less financial capacity. This is especially true for long-term debt, which can lead to steepening of the yield curve.

Italy remains the region’s problem child. Despite the massive EU bailout, 350 billion euros of bonds need to be sold this year. The net new cash needed is €67 billion. This is a significant change from recent years, when net demand was negative thanks to the ECB’s massive quantitative easing purchases. Italy’s debt sustainability is already in jeopardy, with 10-year yields tripling in the past year and currently hovering around 4.3 percent. Adding to the euro zone’s supply, the European Commission plans to raise 150 billion euros this year to finance the EU’s pandemic aid and other growing needs.

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All this makes the ECB’s decision to tighten the financial conditions on three fronts at the same time bold. President Christine Lagarde made it clear during a press conference on December 15 that she would raise interest rates by 50 basis points several times. He also announced that the ECB’s QE reinvestment would be reduced by 15 billion euros per month, and inactive QT would begin in March. It may be a small amount compared to the €5 trillion in bond assets, but the direction of travel is clear. The monthly pace is expected to pick up after the planned summer test. Furthermore, it would be accompanied by a further reduction of the ECB’s balance sheet, which would provide commercial banks with €1.6 trillion in ultra-cheap loans by June.

The relevance of the latest tightening measures may increase. Much of this excess cash circulating in the Euro banking system is held in government bonds. Banks are happy to have a reliable yield above the cost of borrowing (recently negative). Not only would a profitable source of additional profits be cut off, but if interest costs rose, the liquidation of safe but relatively low-yielding assets would turn into a panic. That may be a distant possibility for now, but it’s hard to see banks clamoring to fund more government debt this year. Where are their incentives?

Interest from foreign investors also remains volatile. Although euro government yields are rising, it has access to a number of other relatively high-yielding bond markets around the world. Bondholders fell 23% last year, and Italy’s debt portfolio has also struggled.

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Japanese investors in particular have been steadily selling European bonds over the past year. According to NatWest, they transferred €36bn of the €550bn they held at the end of 2021. This affects France even more, as Japanese funds hold almost 9% of France’s total debt. They were attracted by the fact that they had been making more profits than Germany in recent years, and believed that the two main countries were inextricably linked to the euro project. But rising domestic yields, combined with the cost of hedging currency unattractive to owning foreign bonds, means that the repatriation of Japanese funds will continue.

Europe will always be somewhat confused, but the risk of policy mistakes is clearly on the rise. The memory of the Jean-Claude Trichet ECB rate hike a decade ago that triggered the euro crisis still lingers. Lagarde needs to tread cautiously about raising interest rates too sharply while simultaneously drawing on central bank liquidity. European governments need money, but there is a limit to what they can pay to finance their debt burden.

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This column does not necessarily reflect the views of the editorial board or Bloomberg LP or its owners.

Marcus Ashworth is a Bloomberg columnist covering European markets. He was previously a senior market strategist at Haitong Securities in London.

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