Long-term interest rates have risen sharply in recent months across many advanced economies, raising concerns among bondholders and driving yields even higher. In Europe, this has rekindled fears reminiscent of the debt crisis of 2011-12, with increasing spreads observed between government bonds of core and peripheral countries. Notably, France is now being treated more like a peripheral country in market assessments.

While the European Central Bank (ECB) is better prepared to handle such market tensions than during the previous crisis—equipped with bond-buying programs aimed at curbing yield spikes—it has continued with its policy of quantitative tightening (QT). This involves shrinking the central bank’s balance sheet by allowing maturing government bonds and other assets not to be replaced, effectively reducing the ECB’s holdings of sovereign debt.

This policy, initiated in March 2023, was intended to return the ECB’s balance sheet to a “normal” size after a decade of expansion. However, other major central banks have paused or adapted their QT strategies due to changing market conditions, while the ECB has maintained its course. Critics argue that the full implications of QT were not fully analyzed or debated when the policy was launched.

Lorenzo Bini Smaghi, a former ECB executive board member, highlighted that the notion of a “normal” balance sheet size is not fixed and should depend on evolving economic and market realities. Since the financial crisis, regulatory changes have required banks to hold larger volumes of high-quality liquid assets, such as government bonds, as a safeguard. This demand could exacerbate upward pressure on yields if banks rely on central bank liquidity through collateralized borrowing, which carries a cost ultimately passed on to customers.

Additionally, a shift in market dynamics has seen non-bank entities like hedge funds play a more significant role in government bond market-making. This has increased the risk of liquidity stress during turbulent periods, as seen in episodes involving the U.S. Treasury market. Banks’ incentives to hold more sovereign bonds, driven by the costs of accessing central bank liquidity, may counteract efforts to reduce the so-called bank-sovereign “doom loop,” where pressures on government debt destabilize banks and raise bailout risks.

The ECB has argued that its QT approach is gradual and that the precise transition timeline remains flexible. Nonetheless, this uncertainty has contributed to volatility and heightened long-term yields in Europe.

Given the current economic backdrop, with inflation as the primary challenge, Bini Smaghi suggests that monetary policy should focus on traditional tools such as short-term interest rates rather than on balance sheet adjustments. He advocates for suspending QT until financial markets stabilize and its effects are better understood, cautioning that continuing with QT amid volatility could produce unforeseen negative consequences.