First test of ECB’s new QE policy will be Italy

Ironically, the first major central bank likely to be tested in 2022 is the most dovish: The European Central Bank (ECB). Since the December 16 unveiling of its post-pandemic stimulus policy review, there has been a gradual but persistent widening of Italian government bond yields, showing that weaning markets off unlimited quantitative easing is no simple task.
As Italian yields are the key litmus test for how the euro zone is holding together, it’s a matter of concern if there isn’t some stabilisation. Better to get ahead of a potential crisis than be forced to react to one.
At her December press conference, ECB President Christine Lagarde was careful to portray the March ending of the pandemic QE program, known as PEPP, as a very gentle shape-shift back into the pre-existing Asset Purchase Program (APP). Although the underlying message of support was still clear, there will be less overall monetary stimulus in 2022 than the prior two years. Albeit, nearly three-quarters of net EU government issuance will still be hoovered up by the central bank (down from 125% in 2021).
This tapering is logical because economic growth has picked up substantially, as has inflation. At the same time, despite soaring infection rates and preventative measures being reinstated, the omicron variant appears to cause less serious illness, which should result in less economic damage this time around. Compared to the recent faster taper from the Federal Reserve and interest rate hike from the Bank of England, the unwinding of the ECB Covid stimulus is by far the mildest. But then it needs to be: There are bigger underlying problems.
Unions are only as strong as their weakest point. And for the EU, that remains Italy — and not just its economics but politics, too.
Its latest caretaker government, led by former ECB President Mario Draghi, has performed strongly during the pandemic. It secured more than 100 billion euros ($113.5 billion) in EU-backed fiscal support to help rebuild the Italian economy, which had been on the verge of recession before Covid struck. Relations with Brussels and the major EU nations have noticeably improved, especially with cutting Italy some much-needed slack over its persistent budget deficit.
Lagarde has been careful to make sure that if special measures are needed again the barriers to the PEPP’s reinstatement are relatively minimal. There’s still time for the ECB to defend its patch and protect those spreads to prove old mistakes won’t be repeated.
—Bloomberg

And German bund yields have been rising too, although somewhat less. The spread between the two countries, the best barometer of how the euro project is faring, has widened seven basis points since the ECB meeting. Not calamitous, though it is back to the widest since October 2020.
Yet Draghi may not stay as prime minster for long, having dropped hints just before Christmas that he might seek to become Italian President, a largely ceremonial role, early in 2022. That could be a game changer for the volatile Italian political scene as there is no natural replacement and certainly not one who is such a market favourite.
His skillful handling of the euro crisis a decade ago earned Draghi the moniker “Il Maestro,” a sobriquet it is fair to say he has taken across into the political sphere.
Yet there is no need to worry overly about Italy. Though the ECB may be planning to buy less overall, it has finally learned lessons about how to prepare for inevitable future crises, This time it has baked plenty of flexibility into its still considerable firepower. The Governing Council has been deliberately vague in revealing how much monthly QE it will be undertaking in the first quarter. It could be substantial: There is still a lot of headroom left for the PEPP. Even though it will be retired, the reinvestment of its existing 1.85 trillion euro holdings will comprise around 150 billion euros annually. It will still be buying many tens of billions of euros of new purchases monthly for the foreseeable future. No drought here.

Lagarde has been careful to make sure that if special measures are needed again the barriers to the PEPP’s reinstatement are relatively minimal. There’s still time for the ECB to defend its patch and protect those spreads to prove old mistakes won’t be repeated.

Combined with the prodigious new EU fiscal firepower from the NextGen 800 billion euro recovery fund, which has only just begun to be rolled out in Italy, there are formidable defenses against any bearish raids on the debt of the Europe’s third-largest economy. There’s still time for the ECB to defend its patch and protect those spreads to prove old mistakes won’t be repeated.

—Bloomberg