Investors are wary that the tranquility in eurozone bond markets could breed complacency
James Carville, an adviser to former US President Bill Clinton, wanted to be reincarnated as the bond market, complaining that it was more powerful than presidents or popes. “You can intimidate everybody,” he moaned.
He should have moved to Rome. This year, Italy has had an inconclusive election, a government often on the brink of collapse and an economy struggling
to leave a deep recession. But the bond markets have been noticeably quiescent.
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IN ANALYSIS
Rather than Rome’s borrowing costs rising as investors worried about the security of Italy’s public debt, the difference – or “spread” – between the yield on 10-year Italian and German government bonds has fallen to levels unseen since the eurozone crisis hit the country more than two years ago.
“I don’t recall [prime minister] Enrico Letta mentioning the word ‘spread’ in any of his official speeches,” says Alessandro Tentori, strategist at Citigroup in London.
It is a similar story in other stressed parts of Europe’s monetary union. Apart from a few weeks in May and June, when borrowing costs spiked globally, eurozone yields have followed a downward trend this year.
Spain’s long-term borrowing costs are level pegging Italy’s;
Irish government yields are even lower.
Whether this new phase in the eurozone crisis is sustainable or simply the calm before the next storm will help determine the eurozone’s future. The stability reflects market confidence in the eurozone’s prospects – and the fact that fickle international investors fled at an early stage of the crisis. But overreliance on domestic investors has thrown Europe’s economic integration into reverse and may prove dangerous. While the calm may provide breathing space – lower bond yields cut financing costs – it could breed complacency.
Eurozone leaders are in the midst of far-reaching reforms to strengthen the continent’s financial system. “The danger is that without market pressure, the whole process of eurozone reform slows – and these are the reforms that are required to secure the eurozone’s future,” says Myles Bradshaw, senior European portfolio manager at Pimco.
The euro’s launch in 1999 was the biggest achievement in Europe’s post second world war drive to bring together the region’s economies. The impact on sovereign bond markets was dramatic. During the late 1990s yields converged as investors began to think in terms of a single eurozone market. The risks of a country defaulting, or exiting the eurozone, were ignored.
The complacent mood was shattered in 2009 when the escalating debt problems of
Greece erupted into a crisis. Soaring “spreads” on the debt of governments in the eurozone “periphery” – southern Europe and Ireland – threatened the sustainability of public finances. They prompted sweeping changes by policy makers, including the launch of an emergency government bailout fund.
Bond market pressures remained relentless, however, until July 2012, when the
European Central Bank finally stepped in. Mario Draghi, ECB president, declared it would provide a backstop for sovereign debt markets. To back his pledge to do “whatever it takes” to save the euro, he unveiled an “outright monetary transactions” programme allowing unlimited ECB intervention if necessary in eurozone bond markets.
The OMT programme removed eurozone “tail risk” – a low probability event that would have had catastrophic consequences. The ECB did not state, however, what yields it would deem appropriate in Europe’s monetary union. Its vagueness was deliberate: it did not want markets to test at what point it would intervene.
A danger now is that eurozone bond markets have been lulled into a false sense of security by Mr Draghi. The ECB president saw OMTs only being activated in a fresh emergency – which has not yet happened. But Laurent Fransolet, head of fixed income research at Barclays, argues that markets are fully aware of the programme’s limitations.
“It was like central bank intervention in foreign exchange markets,” says Mr Fransolet. “Everybody was betting one way – being short Europe and extremely negative on everything. Draghi came in and said ‘that’s it’. But we haven’t had any details about OMTs and it is clear the ECB does not want to use them. Do you really think he wants to use them to help Italy?”
Instead, many bond market experts argue this year’s falls in eurozone periphery bond yields are consistent with the progress made towards ensuring the future financial stability of member states and the monetary union.
“The markets see Mr Draghi as a very strong and stabilising figure, and in the driving seat, but they are also looking at governments and seeing some good execution track records – Spain is a good example,” says Spencer Lake, the global head of capital financing at HSBC. “Markets are looking at all that and saying, ‘we’ve probably reached or are near the bottom’.”
The “real game changer”, argues Daniel Gros, director of the Centre for European Policy Studies, has been the ending of countries such as Spain’s dependence on foreign capital inflows. Before the eurozone crisis, Spain, Italy, Ireland, Portugal and Greece were importing heavily and running up large current account deficits.
The effect of the crisis was to slash demand for imports, while structural reforms and lower costs boosted exports, giving the peripheral economies current account surpluses. “That is fundamental because they no longer need capital from overseas,” says Mr Gros. “The OMT programme was the act that took ‘tail risk’ out of bond markets when there was a real panic. What has made the stability more permanent have been changes in real economies.”
A particular beneficiary of the improvement in global investor sentiment towards the eurozone has been Ireland, which is expected in December to become the first eurozone country to leave its bailout programme. Irish bond yields have dropped as foreign investors have sought to grab a share of its apparent success story.
But arguably a much bigger reason for the recent stability in eurozone bond markets across much of the rest of the region is that foreign investors have retreated. So far this year, domestic investors have accounted for almost 100 per cent of the net issuance of Italian and Spanish government debt, according to calculations by BNP Paribas. Of outstanding Spanish bonds, almost 70 per cent is currently held domestically. For Italy, the figure is almost 60 per cent.
The outbreak of the crisis spurred the initial outflows but the “re-domestication” of eurozone bond markets was encouraged by two other factors.
First has been the ECB’s policy of providing large volumes of cheap loans to eurozone banks as its contribution to fighting the global economic crises of recent years – the eurozone’s equivalent of “quantitative easing”. The glut of liquidity encouraged banks to buy government bonds, especially as they could use those bonds as collateral to obtain more funds from the ECB, “round tripping” their investments. Second, have been actions by regulators encouraging European banks to retrench behind national borders, reducing their exposure to riskier assets.
For eurozone governments, increased domestic bond ownership has offered a cheaper way of absorbing debt mountains – domestic investors demand a lower “risk premium” and can often be lent on to buy debt at favourable rates.
“Eurozone policy makers think they have found a third way of dealing with high debt – a better alternative to debt restructurings or inflating it away,” argues Mr Tentori at Citigroup. “They are desperately trying to shape the eurozone in such a way as to make it self-financing.”
Japan has illustrated how a country, with strong domestic ownership, can operate with a level of public sector debt equivalent to more than 200 per cent of national output and still keep official borrowing costs down. Yields on 10-year Japanese government bonds are just 0.6 per cent.
Yet the stability created by “re-domestication” of eurozone bond markets could prove fragile. A mounting concern of eurozone policy makers is the increased mutual dependence between banks and governments in the eurozone periphery, which could quickly exacerbate financial instability if a fresh crisis erupted somewhere in the financial system.
The ECB has set breaking such links as an important objective as it takes responsibility for financial sector supervision. “The issue is how to reduce the fragmentation of the eurozone. The banking system has become Balkanised by national interests, non-trade barriers and investor pressure,” says Huw van Steenis, banking analyst at Morgan Stanley.
The links between banks and sovereigns “basically changes the nature of the eurozone. Banks are acting as the arms of the central bank to help governments avoid default,” argues Thomas Mayer, senior adviser to Deutsche Bank.
Judging the most appropriate level of international ownership of government bonds is hard – too many short term foreign investors would run the risk again of sudden outflows at the first sign of the fresh trouble.
However, the departure of foreign investors has reversed the financial connections that the euro’s launch was meant to foster. The idea under the Maastricht treaty, which led to the euro’s launch in 1999, was for capital flows across the eurozone to spur economic growth and compensate for differences in borrowing costs between different member states.
Without outside investment, the struggling periphery economies could find it even harder to escape recession and produce the growth needed to reduce public-sector debt mountains.
One risk is that resentment grows, fuelling anti-euro political movements. “This is why in the end you need the ECB as a backstop,” says Mr Mayer. “Take away the ECB and the view over the abyss looks scary.”
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There is another hitch on the more immediate horizon. The ECB’s OMT programme is being reviewed by Germany’s constitutional court – a judgment could come in coming months. While the Karlsruhe judges cannot overrule the central bank, it could throw obstacles in its path, reducing its effectiveness in removing “tail risks” from eurozone bond markets.
Investors cannot entirely dismiss the possibility of a debt restructuring or a country exiting the eurozone. Greek government bond holders had losses imposed on them last year, setting a possible precedent despite eurozone policy makers insistence it was a one-off case. Angela Merkel, the German chancellor, and Nicolas Sarkozy, the former French president, at one stage floated the possibility of Greece leaving the monetary union.
Eurozone politicians may not be jolted by bond market pressures in the near future – the dangers are generally longer term, rather than immediate. But investors will remain wary of the current calm. As Mr Bradshaw of Pimco warns: “The existential risks are much lower but they are still there; they are still biased towards the downside.”
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Bringing it all back home
Foreign ownership of Italian and Spanish government bonds was rising before the eurozone financial crisis erupted in late 2009 and 2010. It was a time when cross-border European financial ties were strengthening.
But the eurozone crisis sparked the region’s financial fragmentation. Governments and the private sector faced much higher borrowing costs in the eurozone “periphery” countries than in “core” countries such as Germany. But the “re-domestication” of government bond markets explains the more recent stability.
