Eco week 22-25/ 20 June 2022
economic-research.bnpparibas.com
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EDITORIAL
UNWARRANTED SPREAD WIDENING: MEASUREMENT ISSUES
In recent weeks, the prospect of several ECB rate hikes has caused an increase in Bund yields and, unexpectedly, several
sovereign spreads. Beyond a certain point, higher spreads may become unwarranted. Under such circumstances,
the ECB might consider stepping in to avoid that its policy transmission would be impacted. Determining whether
sovereign spreads have increased too much is a real challenge. Historically, based on a 20-week moving window, the
relationship (beta) between the BTP-Bund spread and Bund yields fluctuates a lot, so this calls for taking a longer
perspective. Using data since 2013, the current spread is in line with an estimate based on current Bund yields.
Clearly, other economic variables should be added to the analysis. It shows the complexity of the task should the
ECB commit to address unwarranted spread widening.
Recently, certain euro area sovereign spreads - the difference between In such case, the ECB considers, with reason, it should step in to avoid
government bond yields in a given country and the yield on German that its policy transmission would be impacted. This is the logic behind
government bonds of equivalent maturity, which are considered as the ‘believe me it will be enough’ speech of Mario Draghi in July 2012
the risk-free benchmark, - have widened significantly. This has raised or behind Isabel Schnabel’s recent speech at the Sorbonne in which
concern that it could influence the transmission of monetary policy and she explained “there can be no doubt that, if and when needed, we can
has even led to an ad hoc meeting of the ECB governing council on 15 and will design and deploy new instruments to secure monetary policy
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3
June “to exchange views on the current market situation” .
transmission and hence our primary mandate of price stability.”
When the ECB signals its intentions to raise its deposit rate, one should
expect that the entire structure of short and long-term interest rates,
both in capital markets (government and corporate bond yields) and
in bank-based financing, will shift upwards. Higher yields on German
government bonds should cause some spread widening for more
heavily indebted sovereign issuers but also for corporates (chart 1).
This can occur even in the absence of a worsening in the near-term
economic outlook. Investors who target a certain yield need to take
less exposure to e.g. Italy or corporate bonds when Bund yields have
increased significantly. The spread can also increase because investors
require some extra yield as a protection against a possible deterioration
of the credit quality.
EURO AREA HIGH YIELD BOND SPREAD AND SOVEREIGN SPREAD
Bund yield (10 year)
%
BTP - Bund spread (10 year)
6
Euro High Yield option adjusted spread, %
5
4
3
2
1
However, beyond a certain point, higher spreads become unwarranted
based on the fundamentals in terms of credit quality. As a consequence,
demand and economic activity might suffer in certain countries
because, due to a disproportionate increase in long term interest rates -
reflecting higher Bund yields and a wider spread -, financial conditions
would tighten more than what the ECB was expecting when deciding
to raise the deposit rate. This gives rise to fragmentation risk. The
disconnect between spreads and fundamentals worsens the economic
outlook, thereby causing higher risk aversion and further spread
widening, ‘giving rise to non-linear and destabilizing dynamics’.2
0
2022
-
1
January
February
March
April
May
June
CHART 1
SOURCE: REFINITIV, FRED ST. LOUIS, BNP PARIBAS
1
.
Source: ECB, Statement after the ad hoc meeting of the ECB Governing Council, 15 June
022.
ECB executive board member Isabel Schnabel defines fragmentation in terms of yields
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2.
policy in a currency union, Commencement speech by Isabel Schnabel, Member of the
Executive Board of the ECB, to the graduates of the Master Program in Money, Banking,
Finance and Insurance of the Panthéon-Sorbonne University, Paris, 14 June 2022
3. Source: see footnote 2.
instead of spreads: “fragmentation reflects a sudden break in the relationship between
sovereign yields and fundamentals, giving rise to non-linear and destabilizing dynamics.”
Source: United in diversity – Challenges for monetary
Historically, based on a 20-week moving window, the relationship
beta) between the BTP-Bund spread and Bund yields fluctuates a lot,
(
so this calls for taking a longer perspective. Using data since 2013,
the current spread is in line with an estimate based on current Bund
yields.
The bank
for a changing
world