How will the ECB contain fragmentation risk in euro area bond markets?

(In para 6, clarifies source of ECB view on new tool)

By Yoruk Bahceli, Dhara Ranasinghe and Stefano Rebaudo

LONDON (Reuters) - As the European Central Bank rushes to exit stimulus and raise interest rates to tame inflation, bond markets are testing its ability and willingness to act against the strains that are starting to hit weaker countries in the bloc.

The ECB is on the case, calling an emergency meeting for Wednesday to discuss the market rout.

Invitations to the meeting were sent out on Tuesday and some ECB policymakers have cancelled plans to attend a conference in Milan on Wednesday.

The meeting has been called after the premia investors demand to hold bonds from Italy, Spain and Portugal relative to safer German debt -- spreads in market parlance -- rose to the highest since 2020.

With ECB key rates seen rising by 75 basis points within the next three months, Italian and Spanish 10-year borrowing costs hit eight-year highs.

Sources told Reuters last week that a large majority of ECB policymakers saw no need for a new tool to help these weaker, highly indebted economies cope with higher interest rates. But the spread widening has left investors wondering when the ECB might step in to contain so-called fragmentation risks and what it could do.

"They didn't say anything new about fragmentation and came up with a more aggressive stance (at last week's meeting) and now they are suprised about the bond market reaction," Nordea chief analyst Jan von Gerich.

Here are some options for the ECB:

1/ DO NOTHING

With inflation at record highs, the stance so far has been to stand back. But the emergency meeting call shows the bond selloff has unnerved policymakers

The 10-year Italian/German yield spread touched 250 bps on Tuesday, levels generally considered the ECB pain threshold. On Wednesday, the very news of the emergency gathering knocked yields off their highs.

Sources told Reuters after last Thursday's ECB meeting that policymakers did not think current conditions amounted to "fragmentation" and there was no debate around a new programme.

"The very fact that the topic was not even approached in any shape or form just told the market that the pain threshold is a lot further away than what we thought previously," UBS strategist Rohan Khanna said.

GRAPHIC: What is the ECB's pain threshold on the Italy/German bond spread? (https://fingfx.thomsonreuters.com/gfx/mkt/znpnegdlqvl/IT1406.PNG)

2/ BE SMART

The only tool the ECB has laid out so far is channelling reinvestments from maturing bonds bought for pandemic-era stimulus back into the markets experiencing stress.

Analysts said on Wednesday this was still likely to be first line of defence to contain any strain.

As spreads widened in April and May the ECB did not gear reinvestments towards southern European debt.

Societe Generale estimates that over the coming year, the ECB will receive 300 billion euros ($314 bln) from redemptions from its emergency PEPP scheme. But it does not see that as containing spread-widening.

Even if the ECB reinvests the entire flow from German and French bonds into Italy -- around 12 billion euros per month -- that will be less than the ECB's net purchases in Italy of almost 14 billion euros monthly since March 2020, SocGen added.

GRAPHIC: ECB net purchases of bonds under PEPP (https://fingfx.thomsonreuters.com/gfx/mkt/byvrjaonave/YBCHART1406.PNG)

3/ REMEMBER SMP, OMT?

The ECB does have other tools at hand, including the Outright Monetary Transactions (OMT) scheme, an unused crisis-time tool allowing for unlimited purchases of a country's debt.

But economists doubt it will be deployed as it requires countries to sign up for a European Union bailout which usually contains unpopular conditions.

Others say the Securities Markets Programme (SMP) is more likely to be revived. This facility would enable the ECB to buy bonds without adding to stimulus already sloshing around the system.

4/ BRING BACK QE

If rapid spread widening raises financial stability risks for the bloc, the ECB could just resume asset purchases. But given it has just ended bond-buying, that move seems unlikely.

Note, however, that on March 18, when the COVID-19 outbreak sent Italian/German bond spreads briefly above 300 bps, the Bank of Italy stepped up bond purchases on behalf of the ECB.

Later that day, the ECB launched its PEPP emergency scheme, calming markets.

"The obvious one would be (restarting) APP (Asset Purchase Programme) but it's difficult to do when you are hiking rates," said State Street's head of EMEA macro strategy Timothy Graf.

GRAPHIC: ECB asset purchases are ending soon (https://fingfx.thomsonreuters.com/gfx/mkt/xmvjowgykpr/ECB1406.PNG)

5/ SOMETHING NEW

Perhaps that's why talk of a new tool has gained ground, something allowing the ECB to target bond-buying specifically at weaker states, deviating from the usual principle of purchasing assets relative to the size of an economy.

However, such flexibility or deviating from the so-called "capital key" could prove a sticking point, especially from Germany's constitutional court.

The ECB "knows that whatever they come up with, they might end up in the German constitutional court," said Andrew Mulliner, head of global aggregate strategies at Janus Henderson.

Nordea's von Gerich said he did not expect a new tool as early as Wednesday but said one was likely in the coming months.

GRAPHIC: Fighting inflation ECB's number one priority (https://fingfx.thomsonreuters.com/gfx/mkt/jnvweogrkvw/inflation1406.PNG)

(This story refiles to clarify source of ECB view on new tool on paragraph 6)

(Reporting by Yoruk Bahceli in Amsterdam, Dhara Ranasinghe in London and Stefano Rebaudo in Milan; additional reporting by Sujata Rao; Editing by Sujata Rao and Susan Fenton)