July 22nd, 2022

Time for duration in the European periphery

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The ECB introduced the new Transmission Protection Instrument which should be seen as a backstop and a new whatever it takes moment, provided you do what is necessary – namely enough reform. It is therefore a significant call to extend duration in the European periphery provided you believe these countries have the will to reform.

What did the ECB decide?

The ECB decided to frontload monetary policy by hiking by 50bp instead of the 25bp expected followed by the flagged 25bp in September, stating that it would continue to raise interest rates and abandoning forward guidance. It is a clear sign that the ECB is trying to regain control of the narrative and is steadily accelerating a hawkish turn.

Transmission Protection Instrument (TPI-Press release 21/7/2022): This credit instrument is meant to deal with unwarranted and disorderly moves in credit curves across the Eurozone and both dimensions are assessed by indicators. Yet, none of the qualities, conditions and legality of this mechanism have been clearly defined. What we know, which is crucial, is that the vote was unanimous and that the instrument will be proportional in monetary policy, a key requirement of the German constitutional court.

Faced with an Italian political class that may backtrack from reform, the use of the tool is reserved to the expert judgement of the council. That means in practice that national governments will have a significant say on the deployment of the tool which should satisfy northern creditors. As some have pointed out, the tool should be seen as a backstop rather than a spread level that has to be tested. The backstop means that under the right conditions, the ECB would buy heavy amounts of Italian sovereign bonds (1-10Y) to reduce its credit risk. For now, word from the council is that this backstop is not yet warranted in Italy. All will depend on the electoral platform of the coalition that gets elected in September.

What does it mean?

European fixed income is typically exposed to the periphery both as a sovereign exposure and as a credit exposure which should benefit from the TPI. At the same time, the ECB has probably not finished its process of tightening faster monetary policy, hence we continue to view short-duration Covered bonds as of interest. Over time though, we see increasing interest in long-duration Covered Bonds.

Source: *investing for their own account – according to MiFID definition

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Time for duration in the European periphery

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