Bond market rout supports ECB pause, says Spanish central bank chief

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A surge in global borrowing costs, triggered by a sell-off in US Treasuries, means eurozone rate-setters have probably done enough to tame inflation, the governor of Spain’s central bank has said.

Pablo Hernández de Cos told the Financial Times that the rout in the market for US government debt had triggered a rise in the cost of credit on the other side of the Atlantic.

“The recent increase in long-term interest rates is not related to domestic factors, such as changes in market expectations for euro area inflation,” he said, referring to rises in governments’ borrowing costs. “Rather, it has been driven by US market dynamics.”

Hernández said the rise would strengthen last month’s assessment by the European Central Bank that “keeping the current level of rates for a sufficiently long period will be broadly consistent” with rate-setters hitting their 2 per cent inflation target “in the medium term”.

Hernández is one of the more “dovish” governing council members of the ECB, which last month raised its deposit rate for the 10th time in a row to a record high of 4 per cent.

Since then bond markets have sold off heavily, driving up the 10-year bond yields of many eurozone countries to their highest level for more than a decade, despite a partial recovery in the past week. 

“We have an additional tightening of financial conditions,” he said, adding that the eurozone economy was already stagnating and the Israel-Hamas war “will certainly not help boost confidence, consumption or investment”.

“Our September assessment [that the level of interest rates was now appropriate] is even more valid today,” he said.

Rising rates have also renewed investors’ concern about high debt levels, such as in Italy, which recently increased its budget deficit forecast, helping to push the spread between the Italian and German 10-year bond yields higher than 2 percentage points for the first time in months.

Hernández said higher borrowing costs underlined the need for governments to start reducing deficits next year. “Fiscal consolidation should get under way in 2024,” he said.

Spain’s national debt is 113 per cent of gross domestic product, the fourth-highest among eurozone countries. The country’s political future has been in doubt since July’s inconclusive national election left socialist prime minister Pedro Sánchez trying to form a coalition government after coming second behind the centre-right Popular party. 

The central bank governor stressed the need for the future government to build cross-party agreement around a plan to reduce the deficit, boost the country’s growth potential and lower unemployment, which has fallen sharply but remains the highest in the EU. 

“For these structural reforms and the fiscal consolidation process to succeed, the policy measures need to be of a permanent nature,” he said, stressing that it was “essential that the design, approval and implementation of these measures are all backed by strong political consensus”.

Most economists think the ECB is unlikely to raise rates again after the central bank described last month’s decision as “a close call”. Eurozone inflation has since fallen to almost a two-year low of 4.3 per cent in September.

Some policymakers have shifted their focus to calling for the ECB to speed up the reduction of its €4.8tn bond holdings by stopping reinvestments in the €1.7tn pandemic emergency purchase portfolio (PEPP) before the end of 2025. This idea is expected to be discussed at an ECB meeting in Athens on October 26.

But Hernández, whose six-year term at the Bank of Spain expires next June, said: “Caution is in order.” The ECB’s flexibility to target its PEPP reinvestments more towards the bonds of a particular country provided a welcome “first line of defence” against a sharp divergence, or fragmentation, in borrowing costs between eurozone countries.

This was especially vital in an environment where growth was slowing and US bond market tensions were raising global borrowing costs, he said.

While he gave a gloomy assessment of eurozone growth, he gave several reasons why Spain’s economy is set to outperform, with the central bank expecting expansion of 2.3 per cent this year and close to 2 per cent in the next two years. That compares with ECB forecasts for eurozone growth of 0.7 per cent this year, 1 per cent next year and 1.5 per cent in 2025.

Higher interest rates would hit Spain’s economy faster, Hernández said, because about 70 per cent of the country’s mortgages had floating rates rather than being fixed for several years. 

This was offset by Spain’s lower reliance on the struggling manufacturing sector and its greater boost from tourism. Spanish household spending has also been lifted by inflation dropping faster than in other eurozone countries and falling unemployment.

A “key difference” from the rest of the region was that relatively low wage rises would make Spain’s exports more competitive, he added: “The net effect of these factors is that Spain is expected to grow faster than the euro area.”