Eurozone divergences are back

LONDON – Monetary-policy tightening is coming to Europe. Following in the footsteps of the US Federal Reserve and others, the European Central Bank has announced that it will discontinue its asset-purchase programme and raise interest rates this month, in a bid to rein in inflation. But, unless the authorities address the differential effect this has on member states’ financial conditions, the eurozone will experience both a recession and a financial crisis.

Anticipating this monetary-policy shift, the eurozone safe yield curve, as measured by overnight index swaps, has been moving up since December, suggesting that financial conditions are becoming significantly tighter. Meanwhile, sovereign spreads have widened, with the risk premium on Italian ten-year bonds more than 250 basis points higher than for German bunds in early June, though the spread has since narrowed somewhat in response to ECB signals that it will take action.

The eurozone has been here before. During both the debt crisis that began in 2009 and the Covid-19 pandemic, economic stress triggered a flight to safety (that is, to the German bund) by investors – especially foreign investors – and a resurgence of home bias in sovereign-bond purchases. The result was financial-market fragmentation along geographical lines. Although the origin of the stress was different, the consequences for the sovereign market were similar.