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Meet the spread that set off the ECB's alarm bell

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By Francesco Canepa, Balazs Koranyi and Frank Siebelt

FRANKFURT – European Central Bank policymakers have gone out of their way this week to reassure investors that stimulus will be maintained at their June meeting, quashing speculation about a reduction in emergency bond purchases and pushing down bond yields.

One market indicator could have prompted the concerted effort by ECB President Christine Lagarde and her colleagues: the spread between German bond yields and so-called “risk-free” rates on the derivatives market.

In an exclusive interview with Reuters published on Friday, ECB board member and top market watcher Isabel Schnabel said she had been taken aback by the fact that borrowing costs for safe-haven Germany were rising faster than rates on Overnight Index Swaps (OIS) of the same maturity.

She took this to mean investors were factoring in fewer purchases by the ECB at a time of increased borrowing needs for pandemic-struck euro zone governments.

“What I found remarkable is that when yields were rising, the safest bonds, including the Bunds, were going up more quickly than risk-free rates,” Schnabel said in the interview.

“This is something to watch because it suggests that something is going on with regard to the anticipated amount of supply and this could be related to expected changes in our asset purchases.”

Graphic: Meet the spread the ECB is poring over: https://fingfx.thomsonreuters.com/gfx/mkt/oakvekdazvr/BUnd%20OIS%20spread.png

The spread between the 10-year Bund yield and the equivalent OIS rate tightened from -26 basis points on March 25 to -11 basis points on May 11, undoing the effect of months of ECB asset purchases.

Schnabel welcomed Lagarde’s “verbal intervention” on May 21, when the ECB chief said it was too early to discuss the end of emergency stimulus. Her comments pushed down yields on government bonds.

“Some of the increases in nominal yields have been reversed and the President’s verbal interventions were very important in clarifying certain aspects of our policy,” Schnabel said.

Board member Fabio Panetta and the governors of the central banks of Greece and France have also signalled that the ECB is not about to turn down the pace of money-printing.

The ECB is now expected to keep the pace of its Pandemic Emergency Purchase Programme steady at its June 10 meeting. It has been running at around 80 billion euros a month since mid-March.

Schnabel said the yield rise was not a worry but a sign that the economy has turned a corner, adding: “The recent yield development was more clearly related to an improvement in the euro area’s growth outlook rather than to foreign spillovers.”

The spread between government bond yields and the Overnight Index Swap (OIS) had already caught the ECB‘s eye at the beginning of the coronavirus pandemic in the spring of 2020.

Then, Chief Economist Philip Lane cited a yawning gap between the OIS rate and an index of euro zone government bonds in March 2020 as an indication investors were taking shelter in safer assets and ditching weaker euro zone borrowers like Italy.

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