The European Central Bank’s (ECB) decision to raise the interest rate by 2.5% in July for the first time in more than a decade can cause financial fragmentation. Raising interest rates was mandatory to combat the intensified inflation pressure from global energy and food prices that are projected to remain high for a while. The market expects a gradual increase in euro-area short-term rates reaching slightly below 2% in 2028 as per figure 1 below.
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Figure 1: Market Expectations for euro-area short-term rates (%) |Source: Breugel (June, 2022)
The ECB forecasts annual inflation in the Euro area rising to reach 6.8% in 2022 compared to an annual CPI of 2.5% in 2021, but it is expected to fall to 3.5% in 2023 and 2.1% in 2024 which implies that it will remain above the bank’s target of 2% over the medium term. Along with persistent inflation, there’s a global pessimistic outlook wherein projections for economic growth is slowing down. The annual real GDP growth rate Spring forecast was revised to lower figures in June 2022 of 2.7% in 2022, 2.1% in 2023, and 2.1% in 2024 compared to the Winter 2022 interim forecast (Wif) 4% in 2022 and 2.8% in the EU in 2023.
Financial Fragmentation is referred to as a “ lack of full traceability of central bank reserves across borders which cannot be explained by technical or fundamental factors”, per the ECB. Fragmentation is a widening of spreads between countries and is unique to EU countries that have sole monetary authority. In a non-fragmented market, reserves flow freely between banks; thus, interest rates are homogenous after controlling for country-specific factors such as the country’s credit risk. Fragmentation imposes risk on price stability; thus, the Euro’s stability. Figure 2 shows a daily chart of the 10-year bond spreads across 5 EU countries: Germany versus countries with a debt to GDP ratio above 100%, France, Italy, Spain, and Portugal.
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Figure 2: 10-Years Government Bonds of Germany, France, Italy, Spain, and Portugal| Source: TradingView
Focusing on two countries Italy and Germany, the 10-year yield spread between them has furtherly widened with Italian bonds surging against the German bonds with the announcement of an ad-hoc meeting of the ECB on the 15th of June concerning the tools to combat the current observed financial fragmentation as yields on the Italian debt surpassed the 4% level during the week, a figure that was not seen since the sovereign-debt crisis, as seen below in figure 3.
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Figure 3: Italy-Germany 10-year yield spread (%)| Source: Bloomberg
Therefore, it is crucial for the ECB to find tools to avoid such fragmentation across the 19 EU countries, and indeed during June 15th’s meeting, the ECB decided that they are going to introduce a new tool to contain the situation to neutralize the threats of financial fragmentation.
One of the instruments created by the ECB during 2011-2012 is the Securities Markets Programme (SMP); however, it was limited in size. The current situation reminds us of the ECB President Draghi in 2012 reassuring the market that the bank will do “whatever it takes” to protect the stability of the EU by issuing the Outright Monetary Transactions (OMT); hence, pushing the market back to a good equilibrium, and this could be a possible tool to be used by the ECB nowadays. In 2015 when interest rates were at low levels, the ECB launched a new program, the public sector purchase programme (PSPP) to tamp down the spreads among euro countries. Resuming a country-specific asset purchase programme could be a possibility, as it proved its reliability during the pandemic in 2020, plummeting the spreads.
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