Do Bund markets signal fears of a 2011 ECB déjà vu?

By Sandrine Soubeyran and Robin Marshall, Global Investment Research, FTSE Russell

Tracking the declines in US Treasury yields, Eurozone government bond yields also fell sharply after the Silicon Valley Bank (SVB) failure. Despite the European Central Bank (ECB)'s well-flagged announcements of further quantitative tightening (QT) in March, fears of contagion spreading more broadly drove investors to seek 'refuge' in short government maturities.

As Chart 1 shows, between March 10^th and March 15^th, Eurozone bond yields fell rapidly across all maturities, and as would be expected during periods of heightened risk aversion, yields fell most on short maturities and the yield curve disinverted.

Market reaction to the SVB failure and related bank runs on First Republic and Signature Bank revived memories of the systemic banking failures during the global financial crisis, particularly when Credit Suisse's liquidity shortfall caused the Swiss authorities to orchestrate a takeover by UBS. This occurred even though the global banking system has much higher reserves, and less leverage, than in 2008-09, when the cross-correlation risk in sub-prime mortgages also undermined the banking system. Thus 1-3-year Eurozone bond yields fell to levels last seen in early February (Chart 2), led by Bonds, the safest haven asset. The move suggested concern over significant further tightening by the ECB had been supplanted by fears over financial stability, as investors scaled back sharply their expectations of further ECB and Federal Reserve tightening.

Further evidence of a major risk-off event can be found in short, dated Eurozone inflation breakevens, which fell sharply, as investors favoured nominal government bonds, over inflation-linked as shown in Chart 3.

But ECB's counter-inflation stance pre-dominates despite financial uncertainty

Despite market concerns about financial stability, the ECB proceeded to raise the deposit rate by 0.50% to 3.0% on March 16, and forecast (average) inflation remaining above the 2% target until 2025. Bearing in mind ECB President Lagarde stressed the ECB's counter-inflation resolve at the March 16 press conference, and the "strong capital and liquidity positions" of the banking system, it is perhaps surprising the market has very little further monetary tightening priced into short rates in 2023-24 (Chart 4) with the December Euribor contract rallying strongly since US regional bank woes surfaced earlier in March.

Markets are reluctant to discount more than a further 25bp of ECB tightening

Furthermore, the ECB has made clear interest rates remain its main policy tool for controlling inflation, given the uncertainties surrounding the impact of rapid balance sheet reduction (via QT), and noted also that the "ECB's policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed…" This suggests the ECB would be reluctant to reverse recent tightening moves by cutting its policy rates quickly and would prefer to provide temporary liquidity if required.

Flat or inverted yield curves also suggest scepticism about more ECB tightening

Meanwhile, more evidence of market scepticism about further ECB rate increases, or higher medium-term inflation may be found in Eurozone yield curves. Despite declining short yields during the March bout of financial instability, deep inversion of the 10/2s yield curve remains in Germany as Chart 5 also highlights. Although Italian and Spanish government bond curves remain positively sloped, reflecting the higher risk premium over German Bonds (rated AAA by S&P, compared to A and BBB for Spain and Italy respectively), both curves have flattened a long way since 2022 and are close to full inversion.

Perhaps scepticism about higher ECB policy rates is driven by fears of a 2011 déjà vu?

One explanation for market reluctance to discount much more ECB tightening is fear of a repeat of the 2011 policy tightening, when the Governing Council raised rates twice (in April and July), for fears of higher inflation, which never materialised, and was then forced to rapidly reverse the rate increases.

With inflation now declining anyway, and a lagging indicator, targeting policy on current inflation, simply because the rate exceeds the target, risks driving inflation to extremely low levels in future. Also, the ECB has noted it sees "no trade-off" between higher rates to tackle inflation and using "other tools - including new ones if required - [to] address any financial turmoil". This increases the risk of the ECB doing "too much tightening, too late", and being forced thereafter to cut rates quickly.

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