ECB/sovereign spreads: rate rises will test Europe’s periphery

The financial fortunes of eurozone members are diverging. The European Central Bank worries about such fragmentation. It reversed its long-held permissive stance on interest rates to a hawkish position last week. Rates are certain to rise next month, as widening sovereign bond spreads forewarn.

Central banks desperately wish to stifle rising inflation, yet avoid the loss of jobs and economic growth that could well follow. Solving that conundrum is complicated for the ECB by a European commitment to prevent financial conditions diverging across the currency bloc.

Already, spreads (versus German Bunds) in Italy and Spain have soared back to levels last seen during the pandemic — nearly 240 basis points for Italian 10-year bonds — hinting at fragmentation. Bank investors will need to pay close attention. At these heights in the past, the ECB started buying government bonds to help reduce spreads.

This year, European banks have waited hopefully for rate rises and the extra loan income these should generate. However, all is not that simple. In Italy, banks remain vulnerable to the falling values of their holdings of sovereign bonds.

The good news is that these institutions are fitter and leaner today than a decade ago. Non-performing loans as a proportion of the total are in line with other European peers. Profitability and importantly capital buffers — up by half — are both higher than at that time.

That is not to say risks have evaporated. Elevated spreads during the previous sovereign wobbles knocked about half a point from Intesa Sanpaolo’s common equity tier one ratio, notes Andrea Filtri at Mediobanca. Intesa alone holds €46bn of Italian and Spanish sovereign bonds. Meanwhile, the bank still plans to return €3.5bn of capital to shareholders this year. That raises a risk it would not meet its 12 per cent CET1 ratio target.

The upshot is that taming EU-wide inflation and avoiding fragmentation may be irreconcilable aims for the ECB. The former matters more than the latter. A deterioration in the capital position of some Mediterranean banks may therefore be an inevitability investors will simply have to live with.