When Christine Lagarde remarked in March that it was not the job of the European Central Bank to narrow the gap in borrowing costs between the eurozone’s stronger and weaker members, she poured lighter fuel on a bond market sell-off.

Nine months on, investors have gone all-in on bets that the ECB boss has changed her mind, and is here “to close spreads” after all.

Ahead of the central bank’s next policy meeting later this week, spreads in the eurozone’s so-called periphery have been squeezed by relentless demand for riskier bonds. The buying helped push Portugal’s 10-year yield below zero last week for the first time. Spain is not far behind, and Italy — the last big eurozone market to offer a significant positive yield over a decade — has seen its spread closing in on its lowest since the region’s debt crisis a decade ago.

With the ECB expected to expand its €1.35tn emergency asset purchase programme by another €500bn on Thursday, investors are increasingly relaxed about holding peripheral bonds despite the explosion in debt levels driven by the pandemic.

“The commitment to keeping spreads low has impressed markets this year,” said Sandra Holdsworth, head of global rates for the UK at Aegon Asset Management. “Why wouldn’t you buy Portuguese or Italian bonds if you know they have the support of the central bank?”

Line chart of 10-year yield spreads versus Germany (percentage points) showing shrinking spreads in the eurozone

The ECB has shied away from explicit targets for bond yields or spreads, with board member Isabel Schnabel telling Bloomberg last week that policymakers have never discussed “yield curve control” — a policy to keep yields at a pre-determined level. But to some investors, her commitment to preserve “favourable financing conditions” amounts to the same thing.

“The ECB is doing some kind of yield curve control and spread control,” said Isabelle Vic-Philippe, head of euro government bonds at Amundi, Europe’s largest asset manager. “They can’t say that, but this is what they are doing, frankly speaking.”

Indeed, markets appear to have far more faith in the ECB’s spread-closing powers than in its ability to meet its mandate of an inflation rate just below 2 per cent. Five-year inflation-linked swaps — a long-term market gauge watched closely by the central bank — show investors are expecting consumer prices to rise at just 1.25 per cent a year in the second half of the next decade.

A stronger euro, which drags down import prices, is not helping: the common currency rallied to more than $1.21 last week, its highest level since April 2018. ECB officials have previously signalled their alarm at the gains, which are partly a reflection of broad dollar weakness, but investors are sceptical about whether the central bank can curb the rise simply by trying to talk the currency down.

Line chart of $ per € showing Euro climbs to highest since early 2018

“The problem with verbal intervention is it only works for a while,” said Jane Foley, head of FX strategy at Rabobank. “Then you need to back it up.”

As long as investors see the ECB’s asset purchases as a tool to keep a lid on spreads, rather than lowering interest rates across the whole economy, that is unlikely to change, she said. The central bank has not ruled out cutting its key interest rate from the current record low of minus 0.5 per cent, but few investors expect it to take that step.

“Actions speak louder than words: we have the biggest shock to activity in living memory and they haven’t cut the policy rate,” said Richard Barwell, head of macro research at BNP Paribas Asset Management. Unwillingness to cut rates in the face of sub-target inflation is feeding the euro’s rise, potentially creating a vicious cycle where sluggish price rises fuel currency strength, Mr Barwell said.

If the ECB wants to hit its inflation target, it will need governments to step up with bigger fiscal stimulus packages, he said. Ms Lagarde, since taking over at the Frankfurt-based institution last year, has urged eurozone member states to loosen the purse strings and has advocated co-ordination between monetary and fiscal authorities in the response to the pandemic.

By controlling borrowing costs, the ECB has given governments the breathing space for more spending. However, relying on the indirect effects of its policies in order to meet its central target potentially puts the ECB in an uncomfortable position, according to Ms Holdsworth.

“There are things Lagarde likes to talk about that the ECB has no control over, like the need for more fiscal support,” she said. “That tells you they are fully aware of the limitations of monetary policy, but they’re not going to admit publicly they are at the end of the road.”