Head of Macroeconomic Research
Summary: In today’s ‘Macro Chartmania’, we talk about fragmentation risk in the eurozone. We use the ECB Systemic Risk Index to track market stress. It was initially developed by Hollo, Kremer and Lo Duca in 2012, in the midst of the eurozone sovereign debt crisis. Market stress remains at an elevated level. But it is now decreasing which seems to indicate that central banks are getting control back of the bond market (where tension was the highest in recent weeks).
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The ECB Systemic Risk Index is based on fifteen financial stress measures such as exchange rates or spreads. Before Covid, we used to identify the level between 0.25 and 0.30 as the danger area for the eurozone which could force the ECB to adopt a more dovish stance or to step in in the market (verbal communication or bond purchasing). Things have changed. The indicator reached a peak at 0.50 in early October without any intervention from the central bank. The last time such a level was reached was in 2011 when investors were wondering if the eurozone would implode. This was before Draghi’s whatever it takes. However, there is good news : the indicator is receding a bit. It now stands at 0.40. This is still comparatively high. But it seems to indicate that bond market dysfunction (which partially resulted from contagion from the UK bond market meltdown following the release of the costly ‘mini-budget’) is disappearing. Looking at the situation this week, it seems that central banks are back in control, for the moment. It is uncertain how long it might last. In the short-term, this means that the ECB has a large room for maneuver to increase interest rates next week. Our baseline is that the Governing Council will need to send a new hawkish message (meaning 50 basis point interest hikes) as inflation continues to increase (it is running at 10 % year-over-year in September in the eurozone) and it is still widespread (going from the manufacturing sector to the services sectors). We think the ECB can accept a higher risk of financial fragmentation in the eurozone in the short-term in order to fight inflation in the long-term, at least until the recession will be officialized, likely in the first quarter of 2023. This means that the ECB has until February 2023 to bring back real interest rates high enough for inflation to finally recede. In the world of central bankers, this is a rather short window of opportunity to act.
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