Italian government bond yields shot up as investors fretted about the economic impact from COVID-19. Italy is now at the epicentre of the outbreak, and has now suffered more deaths than China. Signs of fragility quickly became apparent in the country’s government bond market. The yield on a ten-year government bond spiked, with the spread over an equivalent German Bund rising to 282 basis points on Tuesday. The sudden spike was among the largest monthly increases since the euro was introduced and once again raised questions about the sustainability of the common currency.
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Two weeks ago, we alerted clients to the sharp rise in the euro area market-implied unconditional probability of default indicators. We wrote then that, unless the ECB could convincingly restate its commitment to Mario Draghi’s infamous “whatever it takes”, peripheral spreads would be likely to widen further. Indeed, data through 18 March show a sharp rise in the unconditional probability of an Italian default that we calculate using CDS prices.
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Earlier this week, the ECB took decisive action, announcing a further €750bn of quantitative easing suggesting that in order to avoid a financial crisis, it will do whatever it takes, however it wants to. That announcement came in addition to a previously stated plan to increase its balance sheet by €120 billion, bringing its crisis-fighting measures to €870 billion. By announcing such a large volume of purchases and hinting that the capital key is not necessarily a binding constraint, the ECB is effectively promising to hoover up government debt issuance this year and keep yields for all member states. The ECB’s intention appears to be to provide member states with the fiscal space needed to combat this crisis, rather than attempting to directly stimulate the economy. Early signs suggest that this policy response has been well received by investors with European bonds rallying after it was announced.
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