Stress from the bond market

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Stress from the bond market

As the European Central Bank races towards the exit to tame record high inflation, angst about whether it can contain stress in weaker economies is creeping back into corners of bond markets.

The indicators of stress are comfortably below peaks seen at the height of the 2020 COVID 19 crisis, and nowhere near levels of the 2011 -- 2012 euro zone debt crisis. After the pandemic and war in Ukraine, cohesion is stronger while an 800 billion euro recovery fund supports the bloc and France last month re-elected a pro-European president.

With inflation at 7.5%, the ECB's bond-buying stimulus will end soon - challenging weaker southern European states and putting back in focus as their government borrowing costs versus safer Germany shoot higher.

DZ Bank rates strategist Christian Lenk said it is something I worry about. The question of bond spreads is where the ECB intervenes, where bond spreads are too wide. Here's a look at what stress indicators show.

If the premium investors demand to hold bonds from lower-rated states increases too far above top-rated Germany, the ECB's ability to transmit monetary policy is challenged. At 200 basis points bps, Italy's 10 year bond yield gap over Germany is below the peaks of more than 300 bps hit in March 2020 and 2018, when a new populist Italian government clashed with the European Union over budget policy.

It is near the widest levels since May 2020, after widening 65 bps this year. ING believes that markets could test the ECB's resolve by pushing Italy's spread to 250 bps.

A pandemic-induced financial rout raised fears of the currency bloc's viability, and prompted the European Central Bank to launch its emergency stimulus scheme in March 2020, as a result of a blowout in this spread.

Credit default swaps CDS sit below previous peaks, which is the highest since 2020 for the cost of insuring against a debt default in southern Europe.

Another indicator of fragmentation risk is the spread between CDS contracts issued under trade body International Swaps and Derivatives Association's ISDA 2003 definition and those issued under its 2014 guidelines. The latter includes guidance on redenomination risk and carries a premium.

The gap between two Italian CDS contracts is about 64 bps, about the widest since April 2020, according to Rabobank.

The spread was double current levels in 2018 according to Richard McGuire, head of rates strategy at Rabobank. This gives investors reason to be alert rather than alarmed, according to a historical perspective.

The way investors trade bonds before and after 2013 is worth watching.

A majority bondholder approval is needed for a restructuring including a change in the currency of payment, according to regulators.

Around 415 billion euros of Italian bonds are not covered by CACs, according to UniCredit.

An Italian bond issued in 2008 has gone up 72 bps this year, a year before the CAC ruling and maturing next year. A one-year Italian bond is up a similar amount, issued in 2022 and maturing in 2023.

If the bond outperforms its non-CAC peer, that would suggest that fragmentation worries are returning.