New Structures Address Systemic Risks
Since the 2008 crisis, European and global institutions have created and improved an array of structures to better manage systemic risk. In the eurozone, sovereign-bond-buying programs—including the European Central Bank’s (ECB’s) asset purchase programme (APP, 2014) and pandemic emergency purchase programme (PEPP, 2020)—have helped reduce sovereign spreads during periods of heightened investor concern. Subsequently, the introduction of the Transmission Protection Instrument (TPI, 2022) has reduced market stress and lowered spreads. Once activated, the TPI would enable the ECB to make targeted purchases to support the bonds of individual member states.
In response to the pandemic emergency, the European Commission assumed borrowing powers to provide both loans and grants to specific euro-area countries through the Recovery and Resilience Facility (2021). This represented the first move towards a common debt structure across the EU to help address the needs of individual member states and reduce their funding costs.
Currently, the European Commission is revising its approach to sovereign-debt control. While the original SGP rules prescribed a rigid ceiling on deficits and debt ratios (which were not to exceed 3% and 60% of GDP respectively), the recently agreed revisions to the SGP will allow a more flexible country-specific approach to managing debt levels down. We expect this new approach will both encourage fiscal discipline and help contain market stress should a country fail to meet its targets in any given year—without severely impacting that country’s economic growth.
Stronger Banks Mean Lower Stress
A sounder banking system has also helped reinforce financial stability. While last year’s US regional banking crisis and the failure of Credit Suisse reminded us of the ever-present risks to the banking sector, banks’ balance sheets are much stronger than before the global financial crisis. Higher liquidity ratios and a stronger overall regulatory framework have helped prevent regional crises escalating to global level.
In Europe, the banking supervision reforms initiated in 2014 have helped to improve monitoring and increase the soundness of the banking sector. Although systemic stress increased in 2022, this episode was relatively short-lived, partly because of reduced risks of contagion from the financial sector to the real economy.
Bond Pricing Reflects the New Reality
With the benefit of these additional safeguards, the initial stages of ECB policy tightening have proceeded as planned: the APP quantitative tightening (QT) that began in March 2023 is going smoothly, while the announcement of the roll-off and discontinuation of the PEPP hasn’t disturbed sovereign spreads.
Peripheral government bond spreads remain at or near their lowest since the 2008 crisis, reflecting both stable domestic economic conditions and lower sensitivity to changing market sentiment (Display). Here again, Italy stands out. While BTP-Bund spreads are lower than during the sovereign-debt crisis, they remain volatile in response to Italy’s structural challenges. Even so, we expect those spreads will continue to fluctuate around current levels as QT proceeds undisturbed.
