European Daily: Speculating on an ECB Backstop

• ECB officials have signalled the possibility of a new backstop tool for sovereign debt markets. We think their main objective is to deter a speculative run that could interfere with plans to hike policy rates. But officials have remained deliberately vague regarding the triggers and features of a potential backstop, and we do not look for a pre-emptive announcement.
• Based on historical precedents, we think a backstop could insure against fragmentation risk following large exogenous shocks to the entire currency area or self-fulfilling runs on high-debt sovereign markets. Given rising yields on the back of expected ECB policy normalisation the latter is more relevant currently and although we do not believe that the ECB has a ‘strike price’ for backstopping periphery yields, we think a rapid further widening of spreads could trigger an intervention.
• In the event, we would expect the new tool to entail capital key flexibility and no ex ante purchase limit, but some form of conditionality. We see merit in leveraging the EU’s Resilience and Recovery Fund to implement such conditionality, but details remain speculative.
• Based on our rates strategists’ work we think markets are pricing some probability of an ECB backstop. But further clarity particularly on the triggers and size of such a tool would likely catalyse a tightening of sovereign spreads, with periphery bonds rallying and Bunds selling off further.

ECB officials have signalled the possibility of a new backstop tool for sovereign debt markets. We think their main objective at this stage is to deter a speculative run on any member that could interfere with plans to hike policy rates. In today’s Daily, we address investor questions on such a backstop in Q&A format.

Q1. What have we learned from the ECB?

Governing Council members have emphasized the value of flexibility embedded particularly in the PEPP during the Covid crisis, which could carry over to other tools, such as PEPP reinvestments. President Lagarde moreover suggested during the press conference following the April ECB meeting that such flexibility could be exercised “in situations that demonstrate unwarranted and exogenous causes, that impair monetary policy transmission”. Beyond this broad guidance, ECB officials have however remained deliberately vague to maintain ‘constructive ambiguity’ regarding the triggers and features of a potential backstop.

Q2. What situations would trigger an ECB sovereign backstop?

Both the design and market impact of an ECB sovereign bond backstop will depend on the type of tail risk scenario that it is supposed to insure against. We see two sets of circumstances that could prompt the ECB to step into bond markets in order to fight fragmentation, preserve the singleness of the currency and buy time for a fiscal response.

The most obvious contingency is an exogenous shock that affects the entire currency area and whose economic and fiscal ramifications trigger a flight-to-safety market reaction due to the uncertainty inherent in the situation. As demonstrated during Covid, such an event can justify the use of an instrument with capital key flexibility and little or no conditionality like the PEPP as moral hazard concerns are limited.

The second contingency – a self-fulfilling run on high-debt sovereign markets – can have a broader set of triggers as it is belief-driven. In a recent speech, ECB board member Schnabel described such situations as stress events that “can drive a considerable wedge between a country’s cost of borrowing, as justified by economic fundamentals, and actual financial conditions”, such as during the euro area sovereign debt crisis (Exhibit 1).1 The ECB can coordinate markets on a benign equilibrium in such cases. But moral hazard concerns due to the possibility of laxer fiscal policy in anticipation of ECB insurance call for attaching economic conditionality to ECB interventions, like under the OMT.

Today, the rise of debt servicing costs on the back of expected ECB policy normalisation is putting debt sustainability concerns back into focus. That said, our stochastic debt  sustainability analysis suggests that high-debt countries, such as Italy, are so far able to digest the rise in borrowing costs due to market pricing of roughly 200 basis points worth of ECB deposit rate hikes. While we do not believe that the ECB has a ‘strike price’ for backstopping periphery yields, we think a sentiment-driven, rapid widening of spreads from current levels could trigger an intervention as this would take yield levels into unsustainable territory. In previous work we have estimated the sustainability yield cap on Italian 7-year yields, for example, at around 275 basis points.

That said, we think the bar for an ECB intervention if credit premia widen in individual countries, for example, due to political risk events, is considerably higher. In this case, we think the ECB would tolerate greater market pressure to discipline imprudent fiscal behaviour. The Italian government crisis in 2018-19 is an example of such an episode.

Q3. What would the main design features look like?

The PEPP provides the template for an instrument that addresses external shocks (capital key flexibility, no conditionality, ex ante limited volume and horizon). Designing a backstop for the second contingency (self-fulfilling runs) is more challenging, but more relevant currently. While the OMT remains at the ECB’s disposal, signals that a new tool may need to be crafted suggest that it has lost some of its attraction.

We think a new tool would likely embed i) flexibility to allocate purchases across jurisdictions, the yield curve and time, ii) no ex ante limit on the purchase volume, iii) no consolidation of holdings with other ECB sovereign bond portfolios, iv) some conditionality on economic reforms (see next question), and v) sterilisation of purchases.3 The main distinguishing features of such an instrument compared to the OMT would be greater flexibility in the allocation of purchases (gleaned from the PEPP’s success) and the design of conditionality.

Like its predecessors, an ECB backstop would likely face legal challenges focussing on a possible violation of the prohibition of monetary financing, the principle of proportionality, and possibly the prohibition of privileged access. The most critical features of a backstop as described above would be the absence of an allocation principle, such as the ECB capital key, the lack of an ex ante limit on purchases and the non-consolidation of holdings with other sovereign bond portfolios. While regular asset purchase programmes with a standard monetary policy objective have to observe stricter limits, the European Court of Justice ultimately ruled in favour of the OMT which had similar features in recognition of the emergency nature of the programme with the specific objective of preserving the singleness of the euro area.

Q4. What could conditionality look like?

The OMT carries a strong form of conditionality as participation in a full ESFS/ESM macroeconomic adjustment programme or a precautionary Enhanced Conditions Credit Line – both of which entail corrective actions – is a precondition. Such conditionality may effectively deter imprudent fiscal behaviour. But it also makes the tool less nimble and impactful in a crisis situation.

While the features of an alternative setup remain highly speculative, using an existing fiscal coordination mechanism would stand to reason. The EU’s Recovery and Resilience Facility (RRF) could be a candidate as it combines a risk-sharing mechanism with fiscal conditionality and a monitoring architecture. Currently, a large part of disbursements of both transfers and loans are conditional on the achievement of fiscal targets set out in National Recovery and Resilience Plans (NRRPs) and agreed between EU member states, the European Commission and the European Council.

To credibly incentivise prudent fiscal behaviour deploying an ECB backstop to a country’s sovereign debt market its NRRPs could be amended with additional reform requirements in exchange for, for example, a faster disbursement of already agreed resources. Potentially, there is also scope to leverage unused resources from the loan facility (ca. EUR 200bn) to raise the total allocation to an applicant country.

Despite the advantage of tapping into an active fiscal coordination architecture, recourse to the RRF to implement conditionality has obvious drawbacks. First, the number of actors involved and the requirement of a vote in the European Council to change NRRPs raises the hurdle for effective coordination. Second, the RRF has a finite lifetime as per current legislation, implying that the clock on the ECB backstop itself would be ticking from its inception. Third, fiscal firepower to support the backstop via unallocated loan facility resources is limited, since a further extension of fiscal resources would likely require a modification of the own resources decision.

Q5. How could it be communicated and implemented?

The implementation of a sovereign backstop has four phases in our minds: pre-announcement, activation, deployment and termination.

We are sceptical that the ECB would announce a backstop with all its features pre-emptively on account of both historical precedent and legal concerns. That said, we think ECB officials will reiterate that a backstop facility would be used to address fragmentation risks. This is the pre-announcement phase.

The activation of the actual programme with specific features would then likely require a trigger – either an exogenous shock (like Covid) or a run on a high-debt market (like a rapid and persistent widening in sovereign spreads).

In case of an exogenous shock, deployment could follow promptly upon activation. In case of a run, the announcement effect might turn out to be sufficient to reign in sovereign spreads as with OMT. In any case, deployment could only follow once conditions set out in the programme have been met, such as the agreement on additional reform efforts in the context of the RRF. The termination of the backstop would then either be subject to some objective set out by the Governing Council at the time of its activation or the containment of sovereign spreads closer to the levels observed pre-announcement.

Q6. Are markets pricing a sovereign backstop?

Current liquidity conditions in European sovereign debt markets imply that a precise assessment of policy expectations via sovereign spreads is challenging. That said, sovereign spreads across European high-debt countries have remained contained relative to notable historical precedents. When benchmarking sovereign credit against macro fundamentals and general (but not area-specific) risk aversion, our rates strategists also find that spreads are broadly anchored to fundamentals, despite multiple (simultaneous) headwinds (Exhibit 1). In addition, our rates colleagues have argued that little of the 150-200 basis point long-run drag from EU risk premium and safe asset scarcity on Bund yields has unwound so far. Taken together, this pattern suggests that markets are pricing some probability of an ECB backstop (likely compounded by the possibility of further fiscal risk transfer at the EU level in the context of the energy crisis). Though European credit has likely benefited from the constructive ambiguity on the potential for a backstop until now, we would expect additional clarity, particularly on the triggers and size of an ECB backstop, to catalyse tightening of sovereign spreads, as it would further underscore the ECB’s resolve.

We therefore see scope for ECB officials to lean against spread widening by keeping speculation on a backstop alive without a full pre-announcement.