The ECB met today. Remember, in Europe, before the Iran war, the market was pricing rate cuts/easier money to stimulate weak economic activity.
But soon after the first strikes on Iran, and the related energy shock that followed, the interest rate market started pricing in as many as three rate HIKES to counter the expected energy-induced price pressures.
So, what happened today?
They held rates steady.
And Lagarde acknowledged that the risk to growth is to the downside, while the risks to inflation are to the upside.
So, growth is weakening while inflation pressure builds.
That's the trap for the ECB. Respond to one side, exacerbate the other. The culprit is the energy shock (drives prices higher, while simultaneously dragging the economy lower).
And as we discussed earlier this week, this is the chart (below) that explains the economic squeeze in Europe. It's the premium Europeans are paying for energy (Dutch TTF Natural Gas) relative to Americans (Henry Hub Natural Gas) — and it has been ramping aggressively higher all week.
The multiple hit 7.1x today, a new high for the war, above the March peak.
Now, let's revisit this next chart we looked at back in March…
This chart above represents the risk premium in Europe.
Both the red and the blue lines show the key spread between Italian yields (Europe's most fiscally fragile major bond market) and German yields (the anchor).
The red line is the 2022 period surrounding Russia's invasion of Ukraine. The blue line is the current period (101 trading days into the war). Everything to the right of the black vertical line is the market reaction to the war catalyst.
Now, the obvious observation is that the blue line is much lower than the red line. The current spread between German and Italian yields is much tighter in this U.S./Iran War (and related energy shock).
Is that because the risk to Europe is significantly less?
Well the Italian yields component is signaling a similar degree of risk as it was in 2022 — trading over 4%, which is a level back in 2022 that European sovereign debt (generally) started showing stress, which compelled the ECB to act. The ECB restarted QE (QE by a new name, the "Transmission Protection Instrument") to stabilize bond markets of the weak euro zone countries.
So, this time, Italian yields are back above 4% (up more than 50 bps this month alone). But the spread remains tight relative to the 2022 market stress. Why? Because German yields (the historic low borrowing-cost anchor of Europe) are now more than two times higher than in 2022.
The fiscal rock of Europe isn't what it was just four years ago.
So, the tighter spread isn't telling us Europe is safe. It's telling us the anchor has moved.
