By Sam Vereecke,
CIO Fixed Income


Over the past decades, Europe and most of the developed world have seen structurally low inflation. Until recently, that made central banks very accommodative, resulting in ever-lower interest rates. Since the financial crisis in 2008, central banks have added bond buying as an additional way of easing monetary conditions.

During the euro crisis in 2011-12, Europe was dealing with a different crisis, a fragmentation crisis, where the debt sustainability of certain countries came under pressure. The European Central bank launched its long-term refinancing operation programmes to ultimately support investments in government bonds of the European periphery. Later, other programmes were launched in which the ECB became a buyer of debt. These programmes, often designed as an inflation- or crisis-management tool, ultimately fixed the symptoms of fragmentation by suppressing intra-eurozone spreads on government bonds.

Although the periphery benefitted the most from the bond purchase programmes, in general, they were designed to respect a sense of proportionality in the purchases of bonds of different countries via the capital key. The capital key represents the shares of the national central banks in the ECB’s capital, weighted according to the share of the respective Member States in the total population and gross domestic product of the European Union (EU), in equal measure.

The three concepts, namely, (1) managing monetary policy in a low inflation environment, (2) managing fragmentation, and (3) respecting the capital key were historically not in conflict. Although, respecting the capital key requirement made fighting fragmentation less effective.

Since the COVID crisis we have seen a significant increase in inflation. Central banks initially committed to keep monetary policy loose, as they judged high inflation to be transitory. But, by the end of 2021, many central banks realised inflation was more persistent, leading them to ‘pivot’ their policy and become more hawkish: no more bond purchases and higher policy rates.

Independently from the macro-economic implications, it also meant that the anti-fragmentation tool was being reversed. This led to a widening of periphery spreads in a significant way. The ECB reacted in mid-June by announcing a new anti-fragmentation tool, without specifying the details.

But the devil is in the details of such a programme, because the three concepts above are now in conflict: they are in fact an impossible trinity. Meaning that the ECB will have to let go of one of the three.

    • Monetary policy: Given the current high inflation, tight monetary policy will need to remain in place, although an economic slowdown might give the ECB the excuse to become more dovish early on.
    • Anti-fragmentation: Periphery spreads are still relatively tight, and the competitiveness and funding situation of the periphery has significantly improved. But there is a risk that, if fragmentation is not well managed, we may reach a point where debt refinancing will become prohibitively expensive.
    • Capital key: All historical ECB programmes have tried to carefully respect the spirit of the capital key as the legal risks could be significant if the ECB were to deviate. Nonetheless, de facto this seems to be the one concept that is expected to be weakened to address the risk of fragmentation.


The ECB will have to choose. Ultimately there are 2 possible ways out, one is short term, the other is long term.


Source: DPAM – July 2022

The short-term solution is a muddle-through solution, where the ECB proposes a solution that somewhat compromises on the capital key, formulated in a rather complex way to avoid -or delay- a legal challenge. It is unlikely to be a real fix to anti-fragmentation. It might hold if inflation normalises, and the tool is robust enough to avoid being challenged by the market. If the tool is heavily challenged by the market, the ECB will have to re-iterate with a slightly more convincing version. In either case, it is likely to lead to volatility in spreads, and will lead to a weaker euro overall (the latter is currently being priced in).

The long-term solution requires stronger European integration, a stronger fiscal union, essentially making it a single debt market (or at least a more unified debt market). This requires significant political change but will essentially make the capital key obsolete.

We expect the ECB to come with a short-term solution. However, only the long-term solution will properly fix the fragmentation problem. So…prepare for more volatility.


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