Euro rises as ECB calls emergency meeting

Oh, what a pickle...remember when Christine Lagarde said the European Central Bank was not here to close spreads...then had to row that back as they widened and the euro fell. Well, lightning strikes twice it seems – the ECB will have an unscheduled/ad-hoc/emergency meeting today to discuss the current market conditions – that is, the sell-off in government debt markets. Given there was a scheduled meeting last week, it smacks of panic and a lack of control, but the market is happy to see it happen. European bank shares rose and the euro also rallied, whilst Italian yields came back down. The ECB is clearly worried that ‘peripheral’ bond yields are rising too much...but this is all a bit of a mess coming so soon after the scheduled meeting last week. Here we get to the fragmentation risk and a possible new tool we thought they might signal last week, but didn’t. The spread between Italian and German 10yr yields has widened to more than 240bps, the widest since March 2020 as the Italian 10yr BTP climbed over 4%. Italian yields have fallen back sharply on the ECB update this morning, however. Italian stocks rallied handsomely, too.

What could the ECB do? It’s not easy since tightening monetary policy is rather like the tide going out and revealing who’s swimming naked. The Draghi effect has masked a lot of ills that never really went away after the sovereign debt crisis and this comes down to a question of backstopping Italian debt, which is still too high and growth too low. The ECB could probably first reassure the market that it will do ‘whatever it takes’ to prevent fragmentation, but given this meeting has been called abruptly then it might actually feel that it needs to intervene with a new tool – perhaps a yield spread cap of some sort. Or it could reinvest cash from maturing bonds into those sovereign bond markets that need it. This would undoubtedly introduce political risk and would be challenged in the German courts, as would any new tool. Or it could just QE forever... tricky when you are supposed to be tightening financial conditions. For today it might be enough to tell the market it is working on a new tool/plan in this regard – the lack of detail last week means the Governing Council has not discussed this much and so it might be too early for a specific tool/policy to be announced – plus it has the political and legal dimension to consider too. ECB policymaker Isabel Schnabel said: "Our commitment to the euro is our anti-fragmentation tool. This commitment has no limits." For a second time, Lagarde has to make sure the market knows the ECB is here to close ze spreads. The fact the ECB didn’t bother with this last week is mystery and shows it is still far too complacent and unwilling to get ahead of the curve.

The ECB is kind of stealing the thunder from the Fed today but the US central bank is still the major market event. A lot of banks have changed their forecasts to a 75bps hike and market pricing has move aggressively in that direction. However, I still prefer a 50bps move with the Fed maintaining optionality to do more 50bps hikes for the rest of the year – a strong signal for one in September. Ahead of the meeting the US 10yr yield rose to almost 3.5%, its highest in 11 years, whilst the 2yr yield climbed to 3.45%, a 15-year high.

The news from the ECB lifted the mood at the start of the European session with indices all posting early gains. The FTSE MIB led the way with a gain of more than 2%, whilst the DAX and CAC both rose by almost 1%. Banking stocks led the way as investors pinned hopes on the ECB being able to reduce stress on the sector from its forthcoming hiking cycle with measures to minimise bond spreads blowing out and the kind of financial market contagion that could spark.

After an attempted rally at the open, stocks were lower again in the US on Tuesday, though the pace of the Monday selling eased considerably. The S&P 500 finished the day down almost 0.4% and the Dow Jones fell 0.5%. But tech rallied a touch as the Nasdaq climbed 0.2%. Asian markets struggled but there were some gains for China tech. Chinese retail sales fell less than expected. US futures trade a little higher this morning.

Finally Cathie Wood said the tech sector would bottom out first and rally ahead of the rest of the market. ARKK remains down 68% over the last 12 months and she keeps doubling down for a cool 75bps…nice work if you can get it.