Europe’s Bond Turmoil Need Not Become a Euro Crisis
Stronger banks and ECB backstops reduce the risk of contagion, but markets need clarity on how those tools would work and confidence in the central bank’s leadership. A commentary by Ignazio Angeloni
The current crisis in bond markets has several unusual, and in some respects unprecedented, features. First, its global reach: no country is immune, although the effects differ. Italy, for once, does not top the list of the riskiest countries.
Then there is the fact that the instability originates in US Treasuries, with Treasury secretary Scott Bessent showing more clearly by the day that he is unable to contain it.
France, too, is displaying an unprecedented vulnerability. After ten years of centrist government and on the eve of an election that may bring populist forces to power, it finds itself with precarious public finances and an unsustainable pension system.
Yet none of this should obscure some important strengths in European markets. There is a world of difference between today’s situation and that of 2011-2012, when the sovereign debt crisis threatened the integrity of the euro and the solvency of several countries.
The first difference is the condition of the banks. More than a decade of ECB supervision, helped by a recovery in banks’ margins, has strengthened bank balance sheets in terms of profitability, asset quality, capital and liquidity. Non-performing loans have been all but eliminated. European banks are now in their strongest position for decades, as their share price performance attests.
The damaging feedback loop between public finances and banking systems has not been entirely broken, because banking union remains incomplete and banks are still exposed to government bonds. But the risk of it triggering systemic crises has fallen substantially.
The cost of insuring bank debt, as measured by credit default swap spreads, is much lower today than it was then. This also holds for French banks, even as the spread between French government bonds and their German equivalents reaches unprecedented levels.
The other source of strength is the ECB’s ability to manage crises. In 2012, it was far from certain that the central bank was willing and able to halt the centrifugal forces threatening the single currency.
On that occasion, Mario Draghi’s ability to break with convention in both thought and action made the difference. Today, the ECB is better prepared, with two instruments that have never been used but are ready for deployment.
The first, Outright Monetary Transactions, or OMT, allows the ECB to counter threats to the single currency by buying bonds issued by countries at risk, provided they have agreed an adjustment programme with the eurozone’s rescue fund, the European Stability Mechanism (ESM).
The reform of the fund has never come into force because Italy has not ratified it. This gap is filled by the second instrument, the Transmission Protection Instrument, or TPI, which is intended for countries that meet EU fiscal requirements or, failing that, at least implement the European Council’s recommendations.
The ECB has discretion to activate this instrument without requiring an agreement with the fund.
The ECB therefore potentially has three ways to intervene: halt the rundown of the portfolio it accumulated during the crisis years; activate the TPI selectively; or, in extreme cases, resort to OMT, subject to an agreement with the rescue fund.
The choice of instruments and the order in which they might be used remain open. Whether the third option can be used is uncertain for the reasons set out above. The first would entail resuming bond purchases across the board.
Since 2023, the ECB has allowed securities to mature without replacing them. The TPI, by contrast, allows selective, targeted intervention.
What matters most now is that these instruments exist and that markets clearly understand how they might be used.
Clarity would also be welcome on unresolved aspects of the TPI, such as how costs and risks would be shared among national central banks.
It would also help, needless to say, if there were no doubts about continuity in the ECB’s leadership during the crucial weeks ahead.
A previous version of this article was published in the Italian daily MF-Milano Finanza
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
