The top 10 eurozone countries are expected to sell about 1.3 trillion euros ($1.38 trillion) of sovereign bonds this year. Slightly more than half of this amount will be new money when the debt is paid off. This is an alarmingly large jump in net new supply, which is around 340 billion euros, according to analysts at NatWest Group Plc. Adding pressure is that the ECB’s quantitative tightening process, which began in March, will add at least an additional €150bn to bond markets that will need to be absorbed this year.
Someone, somewhere will have to go and buy all these new securities. Unfortunately, the timing is not right as central banks around the world have become net sellers of assets they have accumulated since the global financial crisis and to fund stimulus measures to combat the pandemic.
This week, Austria, Slovenia, Ireland and Portugal launched syndicated new releases, with France and Italy likely not far behind. This will be a busy month as sovereigns will want to take advantage of their big issuance calendars. The slowdown in annual inflation in Germany to 9.6% in December from a peak of 10.4% in October is welcome, as is the unexpected decline in consumer prices in France. Eurozone inflation is still very, very far from the ECB’s 2% target, but the road to price normalization has to start somewhere. Enticing investors to take responsibility and write off even large portions of European sovereign debt depends on an improvement in the inflationary backdrop. Otherwise, yields will simply keep rising to attract enough demand, risking pushing the limits of European Union cohesion.
The largest additional net borrower will be Germany, which has dramatically changed its approach to financing. This year he plans to sell between 300 and 350 billion euros worth of bonds, about half of which will be new money. This is almost three times the net need of last year. His Economic Stabilization Fund identified about 200 billion euros needed to overcome the huge fall in energy prices following Russia’s invasion of Ukraine.
Since Germany is the benchmark for European government bond markets, the sudden increase in its supply poses a bigger problem for the bloc. As bond yields increase to attract investors, the rising cost of debt will increase in less financially resilient countries. This is especially true for debt with longer maturities, which should lead to twisting yield curves.
Italy remains the region’s problem child. Despite the EU’s large bailout, it still needs to sell 350 billion euros worth of bonds this year. The net new cash required is €67 billion. This is a significant change from recent years, when net need was effectively negative thanks to large ECB purchases under the quantitative easing program. Italy’s debt sustainability is already on the wane as 10-year yields have more than tripled in the past year and are currently around 4.3%. In addition to supplies in the euro region, the European Commission will seek to raise up to 150 billion euros this year to fund ongoing EU pandemic assistance and other growing needs.
All of this makes the ECB’s decision to tighten financial conditions on three fronts a bold one. President Christine Lagarde was the most hawkish during the Dec. 15 press conference, making it clear that several more 50 basis point interest rate hikes were coming. She also announced that passive QT would begin in March with a monthly reduction in the ECB’s QE bank reinvestment of 15 billion euros. It may be a small amount compared to his €5 trillion worth of bonds, but the direction is clear. The monthly pace is also expected to pick up after the scheduled summer review. It also accompanies a much larger reduction in the ECB’s balance sheet, with €1.6 trillion worth of ultra-cheap commercial bank loans disappearing by June.
The urgency of this last tightening measure may increase. Much of this excess cash circulating in the euro banking system is held in government bonds. Banks are happily enjoying a good safe return above the (until recently negative) cost of borrowing. Not only has a convenient source of additional profit been cut off, but the liquidation of safe but relatively low-yielding assets could turn into a stampede if interest rates rise sharply. At present, this may be a distant possibility, but it is unlikely that banks will require the financing of even more public debt this year. Where is their incentive?
The interest of foreign investors also remains heterogeneous. While euro government bond yields are on the rise, this is all relative as there are many other higher yield bond markets available around the world. Bondholders lost 23% last year, and Italian debt portfolios are also struggling.
In particular, last year Japanese investors were constantly selling European bonds. According to NatWest, they got rid of 36 billion euros of the 550 billion euros they had at the end of 2021. This affects France more than most, as Japanese funds own almost 9% of all French debt. In recent years, they have been attracted by the modest additional returns compared to Germany, because they believed that the two main countries were inextricably linked in the euro project. But rising domestic yields, combined with the unattractive costs of foreign-currency hedging holding foreign bonds, mean that the repatriation trend for Japanese funds will continue.
Europe always somehow gets out, but the risk of a political mistake is clearly increasing. I still don’t remember well the ten-year-old ECB’s interest rate hike, led by Jean-Claude Trichet, that triggered the euro crisis. Lagarde needs to tread carefully, raising rates too sharply while draining central bank liquidity. European governments need money, but there is a limit to what they can realistically afford to pay to finance their growing debt burden.
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief market strategist at Haitong Securities in London.
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