Eurozone: Fissures
The dominant global macroeconomic theme over the past six weeks has been — with apologies to our good friends Fannie and Freddie — indications of deteriorating economic conditions in Europe (and I’d lump the UK in there). The big problem is that the global economy is also deteriorating, and meanwhile, the European Central Bank is hell-bent on hiking rates to prevent inflation from spiraling via second-round effects. So on that note, have a look at the following chart, which shows the spread of various eurozone 10-year government bonds over their German equivalents, which are the standard benchmark (as measured in basis points):
Under normal circumstances, the spreads should be reasonably low and steady. Note the deterioration in spreads immediately following the beginning of the credit crunch (July ’07) and just prior to the Bear Stearns blowup (March ’08). These spreads have begun to hit new highs, as the eurozone economy continues to weaken and the ECB leadership remains stubborn (and frankly, somewhat delusional) about inflation.
What is this chart telling us? Well, for starters, the single, Bundesbank-esque monetary policy prescribed by the ECB is not exactly conducive to growth in some of the eurozone’s less competitive economies (Italy), or where there has been a major bubble and now implosion in asset prices (Spain and Ireland, I’m looking at you). So there is certainly a risk premium being added in there. Although these countries share a common currency, it is hard to make the argument that Greek bonds are of the same quality as German debt. Liquidity is probably also a factor, as heavily-traded bonds such as German bunds are selling at a premium as the credit crunch rages on. The most provocative theory, of course, is that the market is pricing in a eurozone breakup. After all, how can such an unhappy economic family continue to coexist? And isn’t it true that every European monetary union has eventually broken apart?
Anything’s possible. But I’m not quite ready to accept that explanation, in part because the logistics of pulling out of the monetary union are probably too complicated to make things worthwhile (a topic that I may expand upon in the future). The eurosceptics would have to admit that the French government issuing debt at 24 basis points over its German counterpart is hardly a crisis. And even Portugal trading inside Italy (a full-fledged G7 member!) is not indicative that the eurozone is about to break up. What is clear, though, is that investors are taking a closer look at the poor fundamentals of some countries that have been abusing their ability to borrow at insanely low rates for too long. Greece and Italy, for example, have debt-to-GDP ratios above 100%, whereas Maastricht prescribes a 60% ratio (Germany, while in violation, hit 65% last year, and is reining in bond sales). Deteriorating growth will not help those ratios. Of course, with G7 bond yields looking like they could head lower, government borrowing costs should remain fairly low even if spreads remain high. But if yields rise while spreads blow out, things could get ugly.
Chances are, inflation will begin to subside by the end of the year, along with commodity prices, which will allow the ECB to give some of the eurozone’s suffering members some breathing room. And the weakening euro will give some respite to exporters. But in the meantime, bond investors are justifiably demanding compensation for rising economic risk.