- What is fragmentation risk?
- What’s happening with euro fragmentation now?
- How to trade euro fragmentation
What is fragmentation risk?
Fragmentation risk is the possibility that some peripheral and debt-laden Eurozone countries might experience a significant rise in their bond yields relative to a benchmark, such as German 10-year bunds. If yields widen sharply, this will raise borrowing costs in these countries to the point where it might trigger another European debt crisis.
Bond yields across the Eurozone have surged higher over the past few weeks, with those of Italy sharply outpacing the rest of the region. The ECB’s June policy meeting exacerbated those moves after it suggested a more aggressive policy tightening – but failed to deliver any new measures to support highly indebted nations in the bloc.
With the ECB halting bond purchases, traders fear that demand for debts of high-risk countries in the Eurozone will fall, resulting in even higher yields in order to attract investors. In June 2022, the 10-year BTP-Bund spread widened to around 40 basis points to approach levels last seen at the peak of the pandemic-induced market turmoil in 2020.
The ECB cannot be too aggressive in tackling inflation as its actions could exacerbate fragmentation risks. There is even a risk therefore that the current situation with stagflation might worsen. The ECB must therefore find new ways to normalise its monetary policy without causing damage to peripheral countries in the Eurozone.
What’s happening with euro fragmentation now?
Markets sighed relief on Wednesday after the ECB announced an emergency meeting to address fragmentation risks. There was a lot of hope ahead of that meeting, as evidenced by the euro climbing back to 1.05 handle on the session.
But as it turned out, the central bank didn’t go far enough. It sent out an underwhelming statement relating to re-investing its pandemic emergency purchase programme (PEPP), adding that it has tasked its staff to look into designing a new tool to deal with fragmentation risks.
Still, that was enough to cause a rally in downbeat Italian bonds, causing their yields to drop sharply as investors’ expectations about risks of fragmentation fell. In truth, the rebounding BTPs were probably more to do with short covering than investors rushing to buy Italian debt. EUR/USD also fell back to near 1.04 handle because if the ECB does apply “flexibility in reinvesting redemptions coming due in the PEPP portfolio,” this is effectively a form of quantitative easing (QE), meaning the disparity between Eurozone and US monetary policies will continue to grow larger.
So, investors saw at least some hope that we are not heading to those dark days of Eurozone debt crisis again as the ECB’s promise to do more alleviated some fears. However, the optimism appears to have been short-lived as by Thursday, European markets – including Italian stocks – were heading down again:
Indeed, there are a few issues that are not addressed. For one thing, the ECB is constrained by the German constitutional court. For another, reinvesting PEPP is far from a permanent fix. As soon as the markets realise these factors, the Italian and Eurozone peripheral bond market sell-off might resume.
Clearly, more is needed to be done. The ball is in their court, and markets will push for an answer. So, the risk of a full-blown debt crisis issue in Europe is not completely eliminated.
How to trade euro fragmentation
Fragmentation is a risk to bonds, equities, indices and the euro. For investors, this is something they could do without. Traders, on the other hand, will not be too bothered since they seek to make profit from both rising and falling markets. If anything, more volatility is good for traders, but bad for investors.
You can take advantage of the volatility caused by fragmentation risk with a free FOREX.com account, which enable you to go long and short on stocks, indices, FX pairs and more. To get started, follow these steps:
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