ECB leaves bond investors high and dry as buying ends

Panel discussion "European Unity in a Disordered World" at the World Economic Forum 2022in Davos
President of the European Central Bank Christine Lagarde takes part at the panel discussion at the World Economic Forum 2022 (WEF) in the Alpine resort of Davos, Switzerland May 25, 2022. REUTERS/Arnd Wiegmann/File Photo

June 9 (Reuters) - European Central Bank policymakers meeting on Thursday saw no need to come up with a new tool to rein in borrowing costs for the euro zone's most indebted countries, as the central bank embarked on its first rate hikes in more than a decade.

The ECB wound down its multi-trillion-euro bond-buying programme on Thursday and pencilled in at least two increases in interest rates this summer to fight record-high inflation.

But, despite widening spreads between safe-haven Germany and debt-laden Italy and Greece, the central bank disappointed investors who were hoping for continued support via a new scheme.

Sources at the meeting told Reuters policymakers did not think current conditions amounted to financial "fragmentation" - a big issue for a central bank making policy for 19 very different economies.

The topic was only briefly discussed at the meeting and there was no debate about announcing a new programme, the sources said.

One added there had been no progress on this since a seminar in April and work would only resume in earnest in September.

ECB President Christine Lagarde told a news conference the ECB would deploy new instruments if needed but she provided no details of what they would look like.

"If it is necessary, as we have amply demonstrated in the past, we will deploy either existing adjusted instruments or new instruments that will be made available," Lagarde told a news conference.

"But we are committed - committed - to proper transmission of our monetary policy and as a result fragmentation will be avoided to the extent that it would impair that transmission."

Borrowing costs have rapidly diverged between safe-haven Germany and highly indebted Southern European states as markets have priced in an unwinding of the ECB's long-running stimulus.

The interest premium investors charge to hold debt of Italy and Greece compared with Germany, known as the spread, has risen by 90 and 120 basis points respectively this year, already their largest annual rises in years.

The ECB's announcement that it would end its Asset Purchase Programme on July 1 before raising interest rates later next month caused those spreads to widen further on Thursday.

Italy's rose to as much as 226 bps, near its highest since the height of the COVID-19 pandemic in 2020, as the yield on its 10-year bond surged over 15 basis points.

The APP, introduced in 2014 to avert potential deflation, has been a key factor that has held down borrowing costs in the bloc's highly indebted states.

The ECB has said its policy will include "flexibility" under stressed conditions and has committed to choosing where it reinvests proceeds from maturing bonds held under its Pandemic Emergency Purchase Programme (PEPP) in the event of stress.

Pressed for details on when such flexibility would kick in, Lagarde said: "There is no specific levels of yields increase, or lending rates or bond spreads that can unconditionally trigger this or that.

"We will determine on the basis of circumstances, of countries, how and when that risk is likely to materialize and we will prevent it," she added.

Investors closely watch for signs of fragmentation, remembering a debt crisis a decade ago that almost broke apart the 19-country euro zone.

"She could have said that something is in the making. That would have been a stronger message," said Carsten Brzeski, global head of macro at ING.

After the ECB stopped adding new bonds to its PEPP holdings in March, buying of Italian debt under the programme fell across April-May, which shows the ECB has not adjusted reinvestments across states, indicating that it is not yet uncomfortable with spreads, analysts said.

Editing by Catherine Evans

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