ECB Insight: Anti-Fragmentation Tool Design a Tough Slog as Council Members Prefer Conservative Approach

7 July 2022

By David Barwick – FRANKFURT (Econostream) – It is very clear that the European Central Bank has its work cut out for it in attempting to come up with an anti-fragmentation tool, Econostream can only conclude after having recently heard opinions on the subject from three more ECB insiders who all seemed keen that such an instrument be designed and deployed conservatively.

Takeaways are as follows:

  • Unveiling:
    • One Council member (person one) said that the Governing Council may in general decide to withhold the particulars of the programme as long as possible in the belief that this approach would be more effective. This person also spoke of ‘whatever we do with this anti-fragmentation thing’, reinforcing the view that the Council was well removed from being able to share details at this point.
    • A second person (person two) said in the context of the various demands made by Bundesbank President Joachim Nagel in a speech on Monday that the instrument ‘needs work’.
  • Deployment:
    • Person one said that ‘we should determine very specific triggers I think in advance. So there has to be an assessment taken at the time when it is taken, but in the end it will have to do with the widening of spreads, but then you need to also have an assessment of what is behind it and if it’s unwarranted when you consider the fundamentals and the widening is very significant and very quick, and perhaps temporarily provide some support.’
    • ‘When we will at the Governing Council see that that kind of tool is necessary, then we will communicate it’, said a third person (person three). ‘The specifics of the tool will depend on the situation and be tailored to the very specific situation in the economy and markets when it gets started.’ Person three also said: ‘We will start it when we see it is necessary. We will intervene as necessary if we see fragmentation risks starting to materialise. … We should only use it in specific cases.’
  • Backstop:
    • ‘I think it should be a backstop’, said person one. ‘It cannot be used for a very extended period. … it would only be I think a temporary backstop if there really is some unwarranted widening of spreads, and then we have yet to discuss and define how exactly you determine what is warranted and what is unwarranted.’
    • ‘The principle should be backstop’, said person two. ‘As long as we don’t have fiscal union, we will have that.’
    • ‘It’s a backstop’, said person three.
  • OMTs:
    • ‘OMT is still there’, person one said, but this was ‘not considered such a good option anymore compared to when it was first announced’ and ‘there’s so much reluctance to discuss the possibility of using OMT. I agree we shouldn’t forget about it, it’s still an effective tool that is there in the toolbox… you could say [the anti-fragmentation tool is] sort of halfway to the OMT’.
  • Capital key:
    • ‘If you only buy the securities, the government bonds of countries where you see fragmentation, you really basically have to forget the capital key at this point’, according to person one. ‘We will be deviating. Of course, for the PEPP, for the APP, you could say that the capital key is what we’re targeting. I don’t think you can do that for the fragmentation tool.’
    • ‘In terms of our instruments, we will always assess it from the proportionality viewpoint, and we will always check whether it complies legally’, according to person three. ‘So, proportionality is always an issue to consider.’
  • Maturities of focus (which Econostream suggested would tend towards the short end):
    • ‘It’s too early to tell the details, but it would make sense to me’, said person one.
    • ‘When the situation arises, then we will see’, said person three. ‘One thing about the maturities that I want to stress is of course that what we’ve seen is that a very low interest rate environment has allowed governments, sovereigns to anchor their borrowing costs at significantly lower levels and longer maturities. So, rate increases don’t mean that it directly hits their refinancing costs. Because the rates are locked in at low levels in large part, and maturities are longer. So, it’s not hitting sovereign debt one to one.’
  • Need for sterilisation:
    • ‘I think there’s a broad understanding that it shouldn’t have to do with the policy stance, so that’s [the need to sterilise] the starting point’, said person one. ‘So you want to make it really so it’s a targeted operation that doesn’t affect the overall policy stance. That’s why you probably want to sterilise.’
    • ‘Yes’, said person three, confirming his desire to see sterilisation.
  • Inevitability of spreads:
    • ‘First of all, I think one should acknowledge that now the ECB is stepping back from the bond market, it is expected that when a big buyer steps back, yields will increase’, said person one. ‘So, it is natural to expect that the spreads will widen. … some fragmentation I think is warranted. … Yields could be quite warranted with policies about to be introduced.’
  • Conditionality:
    • ‘I think there should be some conditions’, said person one. ‘You cannot ask for a programme. I think that’s the problem that some people see with OMT, that you have an ESM programme and you need time to negotiate that, whereas we might need to react quickly if we see that there is some fragmentation.’
  • Sovereign funding costs:
    • ‘Of course the cost of funding for the governments, it does matter’, said person one. ‘But I think we should not be that alarmed about every increase in the government spreads or yields, because it takes a long time to actually feed through to the cost of the government. I think there’s time for governments to react and do their part to make sure that debt is sustainable.’