#ecb ‘s statement last week was the most hawkish ever, yet there are reasons to doubt the central bank’s resolve to proceed as they announced.

In November 11 out of 19 countries in the monetary union reported double digit price increases with three Baltic members registering 20+% price increases year over year. As inflationary expectations are starting to flow into wages, chairman Lagarde had no other option but to push the “panic button” and announce that the Euro Deposit Rate will continue to rise “for a period” of time. The plan would, conservatively, bring the rate at 3.5% with three 50 bps increases between January and March.

Such an increase would likely still be below core CPI for most member states and therefore unable to be sufficiently restrictive, yet, even such a moderate increase would wreak havoc for the most indebted countries, first and foremost Italy. Taking as an approximation the historical average 300 bps spread between the bonds and ECB’s rate, the Italian 10 years rate would rise to ~700 bps, a level even higher than what was reached at the peak of the 2012 euro crisis (see chart). At those levels, Italy’s cost of debt would, in a few years, reach 40-50% of total tax receipts.

More importantly perhaps, the ECB also announced the reduction of its 8.5 trillion balance sheet in March by halting reinvestments of maturing bonds; a crucial measure to reduce liquidity and tame inflation. As things stands Italy’s financing needs for 2023 are approx 450 bil between bonds expiring and new debt. Other EZ members are also planning significant fiscal expansion to counter an unfavorable economic cycle and the energy emergency. It is hard to imagine any meaningful tightening at all without triggering significant conflict among member states.

The ECB will hardly be able to proceed as announced. More likely yet another political/geopolitical crisis will ensue and determine some kind of restructuring of the monetary union with the fragmentation a likely but not the sole scenario possible. I suspect that whatever happens with the Euro project will be come out of some political process rather than an “accident” stemming from ECB’s policy. At any rate, cognizant investors may want to revisit their broadest exposure to EZ sovereign risk and position accordingly.

Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. Twitter @pietroventani for more timely comments and updates

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