European governments are set to unleash a deluge of bonds into markets this year. Investors will demand either a further shift higher in yields or a substantial improvement in the region’s inflation outlook to digest the coming wave of supply, adding to the already daunting monetary policy challenges facing the European Central Bank.
The 10 largest euro nations are expected to sell some €1.3 trillion ($1.38 trillion) of sovereign bonds this year. A little over half of that will be new money, after allowing for maturing debt. It's a scarily large jump in net new supply of around €340 billion, according to analysts at NatWest Group Plc. Adding to the pressure, the ECB’s quantitative tightening process starting in March will add at least an extra €150 billion of bonds markets will need to absorb this year.
Someone, somewhere is going to have to step up and buy all of these new securities. Unfortunately, the timing is poor as central banks globally have become net sellers of the holdings they accumulated in the wake of the global financial crisis and to fund stimulus measures to address the pandemic.
Austria, Slovenia, Ireland and Portugal have all launched syndicated new issues this week, with France and Italy likely close behind. It’s going to be a busy month as sovereign borrowers will want to get a head start on their heavy issuance calendars.
The slowdown in German annual inflation, to 9.6% in December from October’s peak of 10.4%, is most welcome, as is the unexpected deceleration in French consumer prices. Inflation in the euro zone remains a long, long way from the ECB’s 2% target, but the road back to price normality has to start somewhere. Enticing investors to step up to the plate and take down even large swaths of European sovereign debt relies on an improving inflationary backdrop. Otherwise, yields will just have to keep rising to attract sufficient demand which risks straining the limits of the European Union’s cohesiveness.
The biggest additional net borrower will be Germany, which has dramatically altered its approach to its financing. It will look to sell between €300 billion and €350 billion of bonds this year, about half of which will be new money. That is close to triple last year’s net requirement. Its Economic Stabilization fund has identified some €200 billion needed to help address the fallout from the huge energy price squeeze following Russia's invasion of Ukraine.
As Germany is the benchmark for European government bond markets, a sudden upsurge in its supply poses a wider problem for the bloc. As bund yields increase to attract investors, rising debt costs will be magnified across less fiscally robust nations. This is particularly the case for longer-dated debt, which should lead to a steepening in yield curves.
Italy remains the region’s problem child. Despite a large amount of EU aid, it still needs to sell €350 billion of bonds this year. The net new cash required is €67 billion. That’s a substantial change from recent years when the net requirement has actually been negative, courtesy of large ECB quantitative easing purchases. Italy's debt sustainability is already in a precarious position, as 10-year yields having more than trebled during the past year to about 4.3% currently. Adding to supply in the euro region, the European Commission will look to raise as much as €150 billion this year to fund ongoing EU pandemic relief and other growing requirements.
All of which makes the ECB's decision to tighten financial conditions on three fronts at once look brave. President Christine Lagarde was at her most hawkish during the Dec. 15 press conference, making crystal clear that several more 50 basis-point interest-rate hikes are coming. She also announced that passive QT starts from March, with a €15 billion monthly reduction in reinvestments of the ECB's QE pot. That may be a small amount compared with its €5 trillion bond holdings, but the direction of travel is clear. The monthly pace is also expected to pick up after the planned summer review. Furthermore, it accompanies a much bigger contraction in the ECB's balance sheet, with €1.6 trillion of super-cheap loans to commercial banks rolling off by June.
The relevance of this last tightening measure could grow. A large amount of this excess cash swilling around in the euro banking system has been parked in government bonds. Banks have been happily enjoying a nice safe return above the (up-to-recently negative) cost of borrowing. Not only has a handy source of extra profit been turned off, but liquidation -- of safe but relatively low-yielding assets -- could turn into a stampede if interest-rate costs soar. This might be a remote possibility currently, but it is hard to see banks clamoring to fund ever more government debt this year. Where's their incentive?
Foreign investor interest also remains patchy. Although euro government yields are rising, it is all relative, with plenty of other higher-returning bond markets available globally. Bund holders lost 23% last year, with Italian debt portfolios similarly struggling.
Japanese investors in particular have been selling European bonds consistently over the past year. They have offloaded as much as €36 billion of the €550 billion they held at the end of 2021, according to NatWest. This affects France more than most as Japanese funds own nearly 9% of total French debt. They had been attracted in recent years by the modest extra yield over Germany, believing the two core nations are inextricably linked in the euro project. But rising domestic yields combined with unattractive currency-hedging costs for owning foreign bonds mean the repatriation trend is set to continue for Japanese funds.
Europe always somehow muddles through, but the risk is clearly rising of a policy error. The memory is still raw of the interest rate hikes a decade ago by the Jean-Claude Trichet-led ECB, which triggered the euro crisis. Lagarde needs to step carefully in raising rates too sharply, as well as withdrawing central bank liquidity at the same time. European governments need the money — but there is a limit to what they can realistically afford to pay to finance their burgeoning debt burdens.
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