(Bloomberg) — As winter approaches, governments across Europe have been frantically drafting aid programs to protect their citizens from the surge in energy costs triggered by Vladimir Putin’s invasion of Ukraine. There are electricity price caps in France, gasoline discounts in Italy and heating-bill subsidies in Germany.
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These measures are costing a lot of money, notching up a tab in the hundreds of billions of euros, and swelling the region’s financing needs well above historical norms for a fourth straight year. The problem with it all is that unlike the past eight years, when the European Central Bank was happy to print money and buy as many bonds as needed, governments will have to find new financiers.
So rapid, in fact, will the ECB’s policy pivot be that analysts estimate it will force the region’s governments to sell more new debt in the bond market next year — upwards of €500 billion on a net basis — than anytime this century. And bond investors, scarred by the same inflation surge that the ECB is trying to squelch, aren’t in the mood to tolerate fiscal largesse right now. As Liz Truss found out, they will exact a price.
Not even regional powerhouses like Germany and France will be spared from a jump in borrowing costs, strategists say. BNP Paribas SA sees benchmark German bund yields soaring nearly one percentage point by the end of the first quarter.
And for Italy, the most financially vulnerable of the European Union’s big economies, the stakes are much higher still. Citigroup analysts estimate that by early next year, it will take a yield premium of almost 2.75 percentage points over benchmark bunds to entice investors to buy Italian bonds. That’s a level that would trigger alarm bells in Brussels and reignite the nervous speculation that has waxed and waned over the years about the country’s long-term ability to meet debt payments.
“If you move into an environment where European governments issue more debt to face the energy crisis and on top of that you get quantitative tightening, the cost of borrowing will increase massively,” said Flavio Carpenzano, an investment director at Capital Group in London. “Markets will start to call into question the sustainability of debt in countries like Italy.”
Europe’s Energy Tab Climbs Past €700 Billion as Winter Arrives
Barclays Bank Plc sees European government bond net issuance rising to nearly €500 billion in 2023, a record high. That figure accounts for additional funding needs should the economic downturn prove more severe and also takes into account other sources of funding outside the bond markets. The net amount could climb a further €100 billion if the ECB start curbing its reinvestments, so-called quantitative tightening.
In Germany, the epicenter of the region’s energy crisis due to its reliance on Russia, measures include help with heating bills, grants and a brake on gas prices. France has implemented gas and electricity price caps. S&P Global Ratings recently switched its outlook for the nation to negative from stable, pointing to “highly accommodative” fiscal policy.
Italy’s net cash requirement — which factors in gross supply, redemptions, free float coupons and central bank flows — is set to increase by €48 billion, the biggest amount as a percentage of GDP after Portugal, according to Citigroup’s estimations.
The Fashion for Italian Bonds May Turn Into a Fad by Next Year
“Even if Italy toes the European line, it will be issuing a lot,” said Ario Emami Nejad, a fund manager at Fidelity International. “It is unlikely for BTPs to trade close to 150 basis points sustainably, as eventually you have to price all the tail risks of quantitative tightening and issuance with limited upside.”
Tempting Returns
Global fixed-income markets have already undergone a major repricing in what’s been an abysmal year for bonds. At the end of 2021, the German 10-year yield was -0.18%. On Dec. 7, it was 1.79%.
The ECB is not alone in turning the page on ultra-loose monetary policy. The Fed kicked off quantitative tightening six months ago, shrinking its balance sheet by roughly $330 billion as of Nov. 30, while the Bank of England is actively selling gilts back to the market.
The question now is how much further investors will push yields until they feel appropriately compensated. Growing speculation the ECB will start to slow its tightening cycle has already spurred a rally, while an economy in recession will coax investors out of risky assets and into the comparative safety of sovereign paper.
Greater supply should also help ease a chronic shortage of high-quality assets after the ECB spent years vacuuming up bonds to subdue borrowing costs as it moved from one crisis to the next.
“It is 100% true that we’re going to be seeing a sea change on the supply side — but equally, we could see a massive change on the demand side too,” said Annalisa Piazza, a fixed income research analyst at MFS Investment Management. “Yields are interesting and, sooner or later, central banks around the globe will come closer to the end of the tightening cycle.”
Common Concern
But the recent gains may peter out, given the challenges ahead in the first part of 2023, not least because many governments traditionally front-load issuance.
UK’s recent selloff underscored how quickly bond markets can seize up as the expansive tax-cut plans under former Prime Minister Liz Truss ultimately forced the Bank of England into crisis-fighting mode.
There’s also a chance that the ECB unveils a QT plan that’s more aggressive than anticipated, though policymakers have tried to diffuse those fears. Bundesbank President Joachim Nagel said in November that the ECB’s balance-sheet reduction should happen “gradually”.
ECB Seizing the Day for QT Shouldn’t Count on Market Tranquility
Risks connected with high net supply of European government debt were the most frequently-voiced concern at November’s meeting of the ECB’s bond market contact group. One member of that group is Amundi SA, Europe’s largest asset manager, where strategists wrote in a recent report that sovereign issuance should be monitored closely.
“More bonds in 2023 may feel like a lot more bonds without quantitative easing,” said Giles Gale, head of European rates strategy at NatWest Markets.
–With assistance from Sujata Rao.
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