Rising bond yields and tightening financial conditions pose a risk to the economic recovery and, in the euro-area, could increase the probability of the ECB formally adopting YCC

The recent sharp sell-off and bear steepening in global sovereign debt markets has stoked the debate around inflation and raised concerns that tightening financial conditions could prematurely choke off the recovery. These concerns have clearly unsettled policymakers with the BoE’s Andy Haldane recently warning that central banks were at risk of being complacent about the inflation risk, while the ECB’s Isabel Schnabel argued that additional support may be needed if rising yields pose a risk to economic growth.

Chart Source: Bloomberg, Macrobond and Variant Perception

Euro-area bond yields have pushed higher since the beginning of the year and the curve has steepened, undermining the ECB’s oft-repeated commitment to “preserving favourable financing conditions” (arguably de facto, yet informal, YCC). With the short-end of the curve well anchored by continued speculation on the margin about further deposit-rate cuts (and a concomitant adjustment to the tiering multiplier), curve steepening has been driven by the long-end.

Inflation has been one of the main drivers of the long-end re-pricing. Euro-area forward inflation swaps and sovereign breakevens have broadly tracked global oil prices higher. While higher global oil prices reflect an improving global demand outlook which is growth-positive for the euro-area, for the time being inflation risk appears to be the driving force behind the EGB sell-off.

Chart Source: Bloomberg, Macrobond and Variant Perception

The chart below breaks down the 5-year German nominal government bond yield into the real yield and implied inflation breakeven. Since the beginning of the year, inflation has been the main driver of nominal yields, although the contribution from real yields has increased during February, as with the US.

Chart Source: Bloomberg, Macrobond and Variant Perception

Higher yields pose a predicament for most developed economies which are still in the early stages of economic recovery. For the eurozone, where national vaccination programmes have run into severe delays, the economic recovery is particularly fragile. In the event of a sustained tightening of financial conditions, the ECB has few viable options. Given that the PEPP envelope was expanded again in December, and with considerable capacity remaining, scaling up the rate of asset purchases and disproportionately buying the underperformers would be the first port of call.

Chart Source: Bloomberg, Macrobond and Variant Perception

Thereafter, the ECB could consider formalising its commitment to persevering favourable financing conditions into an official YCC policy. While this is perhaps a relatively low probability outcome for now, the unprecedented nature of the pandemic means no option is off the table.