ECB acts on inflation but gas and other worries grow worse

Dan Alderson

Deputy editor

If European Central Bank officials breathed a sigh of relief when their first hike in 11 years did not immediately rattle markets — or even dared believe a more hawkish signal helped confidence — the reprieve was short-lived. Volatility coursed through credit at time of press, and numerous signals point to more pain in August.

In truth, other narratives superseded the ECB’s as it opted for a bigger-than-expected 50bp move, with a moment of optimism leaving unaddressed big concerns both central and external to the ECB plan. Those have already come back to bite.

Euro credit’s mid-month rally persisted beyond the 21 July policy meeting, despite Italy’s coinciding political collapse. Investors also appeared to shrug off a lack of clarity around the ECB’s Transmission Protection Instrument (TPI), the anti-fragmentation tool widely agreed necessary to avert peripheral European dislocation.

Instead it was the reopening of Russia’s Nord Stream 1 pipeline after 10 days’ shutdown — albeit at 40% capacity — that swayed sentiment in late July. This helped take the iTraxx Europe index from its 14 July wide of 126.5bp back to 104.75bp, while Crossover came in from 626bp to 532bp, according to IHS Markit.

Italy vs Greece five-year CDS (bp)

Source: IHS Markit

Italy has caught Greece as the riskiest peripheral European sovereign

“The biggest risk for Europe is recession if there is a gas shock and the war in Ukraine continues,” says one London-based portfolio manager. “The ECB surprised, but we know it needs to continue hiking and it is well behind the curve.”

On 26 July, operator Gazprom announced plans to curtail Nord Stream 1 supply to 20% for further “maintenance”, reminding everyone how fragile the arrangement will be. Coming in concert with G7 warnings the world is “teetering on the edge of a global recession” and a dire Walmart profit warning, iTraxx Europe duly gapped out 8bp and Crossover nearly 40bp on the day. US spreads also surged, but not to the same degree.

Strategists at various banks agree the ECB has prioritised credibility over predictability. But there is no indication of the threshold for TPI to be activated, or how ECB peripheral purchases will be sterilised.

With Italy facing an election on 25 September following prime minister Mario Draghi’s loss of coalition support, five-year CDS had widened to a new wide of 170bp by 26 July, out from just 85.75bp at the start of the year.

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Global credit funds & CLO's

August 2022 | Issue 248

Published in London & New York.