The ECB Needs a Formidable Tool Against Fragmentation

Joachim Nagel, the head of the German Bundesbank, is sabotaging European Central Bank President Christine Lagarde's plans for a comprehensive safety net to prevent yields of peripheral European countries from blowing out. In a coruscating address this week, he argued that it's "virtually impossible" to determine whether a widened spread above benchmark German levels is justified, setting the scene for yet another brutal fight among policy makers that risks sparking a summer of discontent in the bond market. As surging inflation ends the era of negative rates and quantitative easing in the euro zone, a glaring hole in the bloc’s defenses has been revealed. When Italian 10-year borrowing costs spiked above 4% in mid-June, the ECB was forced to hold an emergency meeting to soothe markets. Its pledge to “accelerate the completion of the design of a new anti-fragmentation instrument” has worked as a stop-gap; Nagel’s speech, though, suggests nothing is settled yet.

His hardline approach risks leaving economically weaker euro nations, notably Italy and Greece, at the mercy of bond traders if markets start to doubt the ECB’s commitment to counter any sudden spike in sovereign funding costs. It's a back-to-the future moment that makes Lagarde's already difficult job balancing the interests of the 19 countries using the euro that much more strenuous. The euro is seriously unimpressed, weakening to a 20-year low against the dollar and close to breaching parity.

For now, the bond market has been more sanguine. Italian yields are about a percentage-point lower since the ECB’s emergency meeting, but that echoes declines in German and US yields in the same time frame. There’s no room for complacency.