The European Central Bank needs to fight rising government bond yields despite the hawks

The market focus at tomorrow's ECB monetary policy meeting will be the growing divide between hawks and doves, which poses a threat to investors in terms of the ECB's forward guidance. A stronger-than-expected economic recovery might not warrant further action from the central bank. However, the rising cost of funding in the Euro area remains a problem.

Klaas Knot, the Dutch central bank chief, has recently said that if the economy continues to improve, he doesn't see why the ECB will not gradually phase-out of the pandemic emergency purchases under PEPP by the end of this year to finally end the program in March 2022 as expected. We believe that Knot might be running way ahead of himself for several reasons:

1. The Covid-19 pandemic might not be over yet: despite an acceleration in the pace of vaccination, there is still the probability that another wave may hit the European Union by autumn. It's a risk that the market is not pricing yet because it blindly wants a recovery, which will undoubtedly come but might be choppy.

2. The end of the pandemic might not come together with a full economic recovery. There is the possibility that the PEPP program might be extended beyond March 2022 for the simple reason that the economy will not be fully recovered by the end of this year.

3. It’s unlikely that the ECB will move ahead of the Federal Reserve in terms of tapering. The United States will see a recovery sooner than the euro bloc for the simple reason that monetary e fiscal policies have been working hand in hand. In Europe, fiscal stimulus is lagging, and the money agreed under the recovery fund need to be still disbursed. The Fed expects to taper at the beginning of 2022 at the earliest despite higher inflation and economic expectations. There is no chance that the ECB will move before the Federal Reserve, especially if inflation expectations continue to lag.

4. Tapering means tightening the bloc’s financial conditions, and the European corporate sector is not ready for it. When we speak about rising bond yields in the euro area, we talk about the higher cost of funding for European corporates. While it’s fair to say that a recovery might improve companies' balance sheets, it's also important to acknowledge that the Euro STOXX 600 holds the highest leverage ratio since early 2000. Higher leverage has been possible thanks to the ECB aggressive monetary policies, which reduced significantly borrowing costs. If interest rates suddenly rise, weaker companies relying on capital markets will find it challenging to refinance their debt and risk default.