European Central Bank roiled markets when president Christine Lagarde told coronavirus-ravaged Italy: you're pretty much on your own

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Christine Lagarde flunked her first major test as President of the European Central Bank on Thursday, triggering a brief panic in Europe’s financial markets with comments that revived deep-seated fears about the euro zone’s ability to stick together.

Although she subsequently backtracked, the damage had already been done. Italy’s stock market had tumbled over 16% on Thursday, and its government bonds were again pricing in a clear, albeit still modest, risk of Italy being forced out of the euro by its impossibly heavy debt burden.

While the European bourses and Italy’s spreads were bouncing back on Friday, the timing could hardly have been worse. Italy is in the midst of its greatest public health disaster in decades, with over 15,000 confirmed cases of Covid-19 and over 1,000 deaths as of Thursday. It has condemned itself to a sharp recession by closing down most of public life to contain the virus spreading.

The offense was felt so deeply that the mild-mannered president, Sergio Mattarella, issued a rare rebuke, saying that: “Italy is in a difficult situation and its experience of fighting the spread of the coronavirus will probably be useful for all the countries of the European Union. It therefore expects, rightly…initiatives of solidarity, and not moves that can hamper its actions.”

In her press conference Thursday, Lagarde had been asked about the recent rise in risk premiums—or yield spreads—on Italian bonds.

“We are not here to close spreads,” Lagarde said. “There are other tools and other actors to deal with these issues.”

Her words contrasted starkly with the approach of her predecessor Mario Draghi, whose promise to do “whatever it takes to save the euro” in 2012 had been prompted specifically by markets driving Italian credit spreads to unsustainable levels—and by the knowledge that no-one else was riding to the rescue.

The yield on the 10-year Italian benchmark bond skyrocketed to 1.86%, from 1.19% at Wednesday’s close. The infamous ‘spread’ between Italian and German 10-year yields had, as of the Thursday close, widened to 260 basis points, or 2.6 percent, up from a low of 1.24 points last month.

In an interview later with CNBC, Lagarde backtracked with more orthodox central banker rhetoric, saying that “high spreads clearly impair monetary policy,” a phrase that sadly lacked the punch and authentic sound of her earlier comments.

“Both statements are correct, in their own way,” said Berenberg Bank chief economist Holger Schmieding, in a nod to Lagarde’s broader appeal for governments to take more responsibility. All the same, he said, “It would have been better for Lagarde not to make the first argument so pointedly in the first place.”

A familiar gripe

Indeed, Lagarde had done little more than voice the same frustration that the ECB has expressed for years with eurozone governments that have refused to run more supportive fiscal and economic policies to boost growth in its laggard economies. Government inaction has left the ECB to support demand with a radical policy of negative interest rates and quantitative easing, and German politicians in particular have been quick to deflect public anger at low savings rates back on to the ECB.

Some argued that, with markets in turmoil, it was the wrong time to try to stampede governments into more radical action.

“This is no time to play chicken with the EuroGroup to get more fiscal response next week,” Jacob Kierkegaard, a senior fellow at the Peterson Institute for International Economics in Washington, said via Twitter.

The storm over the spread comments overshadowed what was otherwise an imaginative and bold use of the ECB’s limited room for maneuver. It held off from cutting its deposit rate, but earmarked an extra 120 billion euros ($134 billion) for quantitative easing over the next nine months, and sketched out operations over the next year that will allow banks to refinance up to half of their business loans at a rate likely to be around -0.75%—a potent incentive not to call in credit and tip viable companies into oblivion.

But arguably the most powerful elements of the ECB’s package were lost in Lagarde’s failure to share the podium on Thursday with her chief banking supervisor Andrea Enria. The ECB’s supervisory arm had simultaneously announced far-reaching measures letting banks run with much lower levels of capital and liquidity while they work through Covid-19-related problems with their clients.

On Wednesday, the Bank of England had paraded all of its top management at a press conference after monetary and prudential supervisory officials had weighed in with measures to support the U.K. economy. The U.K. government announced its own fiscal stimulus later in the day, in a carefully-orchestrated show of coordinated action. Enria’s absence, by contrast, left the ECB’s response looking disjointed, and placed what proved to be an impossible burden of communication on Lagarde alone.

Limits of monetary, fiscal policies

Admittedly, there is probably nothing Lagarde or Enria could have said or done to push European markets into the green on the worst day for global equity markets since 1987, a move triggered by U.S. President Donald Trump’s misjudged address the previous evening.

“The adverse market reaction may not be just a market verdict on the ECB’s package,” said Berenberg’s Schmieding in a note to clients. “It may reflect a growing realization that monetary and fiscal policy cannot be the genuine circuit-breakers in a medical emergency.”

German central bank chief Jens Weidmann also complained to the Frankfurter Allgemeine Zeitung after the meeting that “there were, possibly, too high expectations of the European Central Bank, just as there were too high expectations of the Fed and the Bank of England.

“At the moment,” Weidmann said, “central banks are not the first line of defense.”