Rising interest rate spreads not yet a cause for concern
Since the beginning of 2022, risk premiums on various financial instruments have been rising. These include intra-EMU government bonds, corporate bonds and interest rate swaps. Most of these risk premiums are coming from exceptionally low levels. Their recent rise so far is partly a normalization and does not constitute a major cause for concern until further notice. One reason for the rise is the general increase in uncertainty, as illustrated by the rise in the VIX. The increased risk to the financial sector from the financial sanctions following the outbreak of the war in Ukraine also plays a role. The ECB’s policy reversal, particularly the announced end of its quantitative easing and the prospect of a first interest rate hike this year, also plays an important role. To keep intra-EMU spreads from rising too far, the ECB is relying mainly on its flexibility in reinvesting its PEPP portfolio. After all, a policy of spread control, inspired by the Japanese central bank, is practically impossible in the eurozone.
Since the beginning of 2022, risk premiums on various financial instruments have been rising. In a longer-term perspective, that movement started from an exceptionally low level. In this sense, the recent rise is a step toward normalization, rather than an alarm signal for financial stability.
Among other things, interest rate differentials against Germany on government bonds are moderately rising. That movement is more pronounced for fiscally vulnerable countries such as Spain, Portugal, and especially Italy (Figure 1). However, the magnitude of the current spreads is still far below their levels during the European debt crisis of the early 2010s.
The 10-year spread on European corporate bonds relative to the euro swap rate has also been increasing since the beginning of this year (Figure 2). It is worth noting that the risk premium on financial sector corporate bonds is still higher than that of the non-financial sector, and that it also rose more sharply. However, spreads are still well below the levels during the March 2020 pandemic shock, the European debt crisis or the global financial crisis.
Finally, the spread between the 10-year euro swap rate and the German government rate also increased (Figure 3). We can interpret that interest rate differential as the additional return the market requires for an exposure to the financial sector rather than an exposure to the less risky German government.
What drives the risk premiums ?
A number of factors underlie these higher risk premiums. For starters, general risk perceptions in financial markets have risen noticeably since the beginning of the year. For example, the VIX index (the stock volatility of the S&P500 that option prices take into account) rose sharply from 17% on January 3, 2022 to around 30% today. While that is not yet a crisis level (when the pandemic broke out in March 2020, the VIX reached 83%), it illustrates the sharp increase in uncertainty.
It is also not surprising that the risk to the financial sector is rated higher by the market in the context of the direct and indirect consequences of financial sanctions in response to the Russian invasion of Ukraine. This is also consistent with the increased swap spread. This was temporarily distorted upwards by the ‘flight to quality’ that briefly pushed German yields back below 0%. This caused the swap spread to peak at around 81 basis points on 7 March. However, this effect has now played out. The current swap spread of around 70 basis points is still significantly above its 2021 price band of 30-40 basis points.
The main reason for the rising interest rate spreads, however, is the policy reversal by the ECB. It is stopping its net purchases under the Pandemic Emergency Purchase Programme this month. Based on its latest communication, we expect that the ECB will also stop net purchases under its general Asset Purchase Programme (and thus also the Corporate Sector Purchase Programme) in the third quarter, opening the door for a first rate hike in the fourth quarter. This reduced role for the ECB as the main buyer and liquidity provider in the bond market is putting upward pressure on interest rate spreads.
The ECB’s phasing out of liquidity injections and the rising German benchmark interest rate also take pressure off investors to look for extra yield in riskier assets, such as peripheral government bonds or corporate bonds (‘search for yield’). This also contributes to a spread normalization.
ECB in a difficult position
There are probably limits to how far the ECB is willing to allow intra-EMU spreads and fragmentation to widen. However, an explicit policy of spread control, inspired by the Japanese central bank’s yield curve control policy, is impossible to implement in the euro area, with different national interests. The ECB therefore mainly refers to its flexibility in reinvesting maturing bonds from its PEPP portfolio to counteract ‘market fragmentation’ in the euro area. The question is, however, whether that will be sufficient in moments of crisis with self-fulfilling expectations of rising spreads. In such a situation, only an explicit confirmation of the ‘whatever it takes’ promise could bring relief.