There is no going back to the noughties for the euro-region bond market.
Euro-area spreads have narrowed sharply as a result of asset purchases by the European Central Bank, but investors continue to demand a risk premium for holding the sovereign debt of countries such as Italy on the periphery of the eurozone over core members like Germany, even with the bank expected to reinforce its role as a backstop to the market by increasing its asset purchasing package in December.
In March, ECB President Christine Lagarde spooked the bond market by announcing the bank was "not here to close spreads," but the introduction of the €1.35 trillion pandemic emergency purchase program, or PEPP, free from the bank's normal capital keys restraints that prevent the ECB buying more than a third of a country's debt, has done exactly that, providing a backstop of demand for the highly indebted euro-area countries including Italy, Greece and Spain.
The spread between higher yielding Italian 10-year debt — or BTPs — and German 10-year bunds has eroded to just 116 basis points as of Nov. 27, the lowest level since April 2018, having been as high as 265 bps this year in April, as the Italian yield fell to an all-time low of 0.56%.
Yet spreads have not shifted back to the lows that predominated before the great financial crisis of 2008-2009. Between 2000 and 2008 the spread between 10-year BTPs and bunds averaged just 20 bps.
"That was in a different era when risks were not perceived, and the mistake is not now, it was back then," said Andreas Billmeier, sovereign research analyst at Western Asset Management.
The illusion that all euro-area debt was equal was shattered by the spiraling European debt crisis which saw the BTP-bund spread widen to a peak of 524 bps in July 2012 as the yield on Italian debt shot to 7.59%. Greek debt peaked at 46.9% as doubts about the future of the euro project intensified.
However, while the ECB has not included yield control in its mandate, the bank's asset purchase program, or APP, has effectively removed the risk of a big rise in Italian yields. With the ECB expected to announce an additional €500 billion injection into its PEPP program in December in response to the second wave of lockdowns and an investor class searching for yield, the conditions could exist for the spread to shrink further.
The ECB's recent behavior suggests that it is not trying to completely eliminate spreads. The bank has scaled back its bond purchases since the spring/summer highs as the threat of spiraling yields diminished. By October, monthly asset purchases had halved from the peak of €120.32 billion in June to €61.99 billion.
"The longer we are in an environment of continued ECB purchases, the more support there will be for narrower spreads wherever there is pick-up left. Still, I don’t see the risk premium disappear altogether," said Jan von Gerich, chief analyst at Nordea Research.
Morgan Stanley forecasts the BTP-bund spread to tighten to sub-100 bps by mid-2021, dropping to 85 bps by the end of that year as governments reduce supply of bonds and the ECB maintains purchases. The investment bank expects net issuance by euro-area countries in 2021 to total €540 billion, whereas the ECB will have a combined €1.3 trillion-€1.4 trillion of combined PEPP/APP firepower for the year, having purchased an expected €1.1 trillion in 2020.
Analysts note that the combination of continued support from the ECB, the arrival of a vaccine for COVID-19 and improved economic growth will likely narrow spreads further. Yet, there remain significant hurdles for long-term investors, such as pension funds to accept Italian debt as a risk-free asset equivalent to German 10-year bunds, which have been negatively yielding since May 2019.
"Investors buy along with the ECB. You have to make your question 'without support would the situation be different?'" said Jesus Martinez, senior fixed income portfolio manager at Aegon Asset Management. "For spreads to tighten further, you need to convince a larger set of investors, and the only way is to produce a plan of a healthier — or more resilient — way to grow out of your debt."
The debt profiles of Germany and Italy are very different.
Germany's is the world's fourth-largest economy and a major manufacturing export hub with pre-pandemic government debt-to-GDP of 59.5%. By contrast, the IMF forecasts Italy's debt will rise from 134.8% of GDP in 2019 to 161.8% this year, and remain above 150% until after 2025.
"My concern as an investor is the lower the yield, the lower the appetite for making substantial reforms," Martinez said. "There's a lot of uncertainty still on how the pandemic is managed. Will there be a large second wave? A third wave? What will happen with the vaccine? And the structural problems are still on the table such as long-term growth. The market cares about what happens in the future, can Italy build a long-term sustainable growth?"
There is also the possibility of Lagarde being faced with another choice about whether to close spreads.
"If the fiscal component [of the stimulus] comes through and produces domestic inflation then I would expect long-term yields to go up reflecting those inflation dynamics. What is the ECB here to do? If yields go up for good reasons, then the ECB shouldn't stand in the way of that," Billmeier said.