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Bond Traders Hunt for the Trigger of the ECB’s Anti-Crisis Tool

·4 min read

(Bloomberg) -- When a central bank sets a red line, the market will start looking for ways to test it. And now that the European Central Bank has unveiled the initial details of its anti-fragmentation tool, traders say the next step is to figure out what it takes to set it in motion.

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They’re asking: How wide do European spreads need to be? What are the conditions for policymakers to start supporting bond markets, and to what extent does Italy’s own political chaos prevent the ECB from taking action?

“We would anticipate the market will test the ECB’s resolve,” said David Zahn, the head of European fixed income at Franklin Templeton. “The market is interested in when or at what level the ECB would step in to help restrict government spreads widening.”

The metric that everyone is watching is the spread between Italian and German bonds. Some strategists have speculated that the trigger point might be around 250 basis points, just above the peak in June, when the ECB called an emergency meeting and announced its anti-crisis tool. The gap was around 235 basis points on Friday.

But the situation is complicated, and there are good reasons for the Italy-Germany spread to be wide right now. Italy is facing elections after the resignation of Prime Minister Mario Draghi, and the entire continent has been shaken by the war in Ukraine and energy shortages.

After the ECB’s announcement on Thursday, people familiar with the matter told Bloomberg that while officials agreed on the creation of the instrument, they didn’t consider its use warranted under the current circumstances. Market jitters in Italy are related to political developments that are not the focus of the measure.

Some ECB Officials Were Initially in Favor of Smaller Hike

“All eyes are now on the ECB’s tolerance for widening spreads,” said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International.

“The prospect of a new election in Italy, with far-right parties in the lead, means that Italy is unlikely to meet the conditions, at least in the short term, leading to concerns around whether the ECB will intervene or not,” he added.

Ahmed said the strict criteria for the anti-crisis tool, formally called the Transmission Protection Instrument, could limit its use. But some of the details are open to interpretation and others say the ECB has plenty of flexibility in its bond purchases.

Here’s a Closer Look at the ECB’s New Anti-Fragmentation Tool

There’s also a view that the ECB has been successful in controlling disorderly spreads, simply by talking about the potential for bond purchases. The decision to hike interest rates by 50 basis points, instead of 25, was also interpreted as a signal that the policy makers are determined to bring down inflation.

“The medicine administered today of a 50 basis point rate hike, sweetened with a dose of bond buying through the new Transmission Protection Instrument, is a step in the right direction,” said Hetal Mehta, senior European economist at Legal & General Investment Management. “The conditionality of the tool appears to be loose.”

To Andrew Mulliner, head of Global Aggregate Strategies at Janus Henderson, investors shouldn’t think of the TPI as a tool at all. It’s meant to act more as safeguard against the kind of fragmentation that threatens the integrity of the euro area, he said.

“The vagueness of the trigger for activation means markets cannot explicitly test the tool,” he wrote. “This clearly limits any immediate impact. However, that is not that the point, this is not an active tool but a backstop.”

Even so, with markets as volatile as they have been, traders might be tempted to push their luck.

“There’s a bit of dry powder for macro investors to test the ECB’s pain threshold for wider peripheral spreads in the coming weeks,” said Viraj Patel, a strategist at Vanda Research. “In other words, it may be too premature to be long BTPs.”

(Updates Italy-Germany 10-year yield spread in fourth paragraph.)

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