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Monday, May 12, 2014

Have borrowing costs in the eurozone periphery come down too far, too fast?

Over on his Forbes blog, Open Europe’s Raoul Ruparel asks: is there a bond bubble in peripheral Europe? The thurst of his answer is that, while there are good explanations for why costs have come down so far and so fast, they could certaintly have side effects, not least because people misinterpret the reasons for the move. The full post is here, but below are the key points:
What is driving this and is it a bubble?
There are three key factors at work here:
  1. ECB President Mario Draghi’s promise to do “whatever it takes” to protect the euro combined with the unlimited bond buying policy of Outright Monetary Transactions (OMT) has driven borrowing costs down since mid-2012. This effect has been amplified by the expectations of further ECB easing, particularly some form of Quantitative Easing (QE), which would bring yields down even more.
  2. There has been some success in terms of eurozone reform, particularly with the successful end to the Irish and Portuguese bailouts as well as these countries’ return to the markets, along with Greece. The eventual agreement on banking union and other aspects of trying to correct the structural flaws in the euro (although I believe it is far short of what is needed) has also contributed to the positive sentiment.
  3. Possibly the most important factor though is the very low inflation in the eurozone (and even deflation in some countries). Over the past six months this has pulled the borrowing costs across the eurozone down.
This final point is driven home by looking at the rough and ready version of the ‘real yield’ on ten year debt in Europe (10yr yield minus HICP inflation). As the graph below highlights*, when this is done the UK actually borrows at a real rate which is 2% below Ireland’s.


Could this present a problem? (Hint: Yes)
While the process of collapsing bond yields in peripheral Europe is explainable it does still present some serious causes for concern.
  • The huge demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries. Debt levels have continued to rise – exacerbated by low inflation – while many countries are barely posting any economic growth.
  • More concerning though is that this creates very perverse incentives. Many governments can already be seen professing the success of their policies, citing falling borrowing costs and buoyant financial markets. In reality, these are much more down to the ECB and inflation effects mentioned above.
  • The risk is that complacency seeps in (some of which can already be seen) and that the reform process in these countries stalls. Italy and France are prime examples of this. While the European Commission does have additional powers now to encourage further reform, when push comes to shove there is little it can do to force reform on an unwilling political class and population, particularly one with low borrowing costs.
  • As detailed here, the banking union looks insufficient to break the sovereign banking loop in the eurozone. The efforts to improve the structure of the eurozone have slowed, the risk is they will grind to a halt until the threat of a crisis returns.
  • The performance also looks strange relative to countries such as the US and UK which have always borrowed in their own currency for which they are solely responsible and have clear fiscal and central bank backing. Even with the changes to the euro structure and the ECB promises it’s hard to say that, in another crisis, the same issue wouldn’t arise with regards to a comprehensive lender of last resort (let’s not forget, the OMT comes with plenty of conditions and is limited in scope). Even though accounting for the inflation impact, the difference in risk between peripheral eurozone countries and the likes of the US and UK does seem to be being underestimated.
Ultimately, the crisis highlighted that too much price convergence without economic convergence and reform in the eurozone can actually be a bad thing, with resulting perverse incentives and negative outcomes. While the price action in peripheral bonds might not yet count as a ‘bubble’, investors and politicians would do well to remember these lessons when interpreting the record low borrowing costs.

5 comments:

Rik said...

Low interest because low inflation can only be properly explained if one looks at inflation as inflation expectancy.

On that thinks simply donot add up.
Need growth and a lot of it to solve the problems down South. Meaning higher inflation. Low expectancy means however low growth. And basically over the whole duration of the loans involved.
QE is being priced in should be to generate inflation. However likely lead to even lower rates.

At the end of the day both in a positive and negative scenario rates should be higher especially 5,10 and more Y.
You have growth an subsequently inflation and so need higher rates.
Or you have a long term economic problem (imho the far more likely situation) where the risk is much higher and so the rates should be.

Simply looks like that the markets are taking the best of both world. However these best simply in reality donot combine.

Jesper said...

It is all subjective and whether or not it is a bubble is yet to be seen.

My guess is that the insiders in the countries specified will do what it takes to continue to get their privileges. Unemployment, corruption etc is of no relevance to them as long as someone is willing to fund them. The funding can be borrowing, taxes or transfers from other countries, these people aren't too fuzzy about it.

Rik said...

@Jesper
There are of course no absolutes for the future but you can reasonably estimate if there is a bubble or not.
And so you can reasonably compare the chance that there is a bubble (as a consequence of policies) with the cost/benefits thereof.

It is hard to see that here we donot have one.
Just one comparison.
Interest should be roughly:
I(nflation)+riskfree premium (2% roughly)+ riskpremium for more risk than riskfree.
Using that interest for eg Spain should be much higher.
Basically it is now priced at being riskfree. Which it is in no way.

The problem with nearly all bubbles is that they usually deflate in a very short period of time. RE bubbles are a bit different.

A problem for bonds is that when the process reverses (interest goes up) it not only has consequences for the P&L of the debtor (Spain here) but also and probably even more important on the BSheet of the creditors. 1% higher interest means at low rates like now a drop with close to 10% in value for 10Y bonds.
And with that goes:
people's saving,
bank's capital/BSheet (at least the ones based on proper accounting principles) (Spanish banks own enormous amounts),
pension's.

Spain is a complete mess on top of it. According to official figures its GDP dropped less than that of the UK in the crisis. Anybody with more than 2 braincells believes that?
Problem is all that not accounted for drop in GDP has at some point to be absorbed by growth (which will not be shown because of that).
Anyway if a company and a structural lossmaking (deficitmaking) one would have similar accounts it would be removed from nearly all exchanges in the world and at best its shares would be tanked. Here nothing of that kind.
On top of that it is a country still largely liable for problems in its bankingsector (of which at least half are de facto bust).

It is as the article says simply for the by far largest point because of the ECB. Which for a large part in itself is German guarantees.
These guarantees however are not natural like with an own CBank. If a Wilders like guy comes to power (and not only in Germany) it is game over.

The misconception markets have is that if things go for some time they will keep going.
The Euro is however mainly an political thing and the dangers are mainly political. And political in a way that is different from the US, UK, Japan.
At the end of the day it is guarantees given by the current Northern governments that keep the thing up. Another sort of government there and it can be reversed.
And Euro-sceptics are on the rise. Basically it is the rise of populist parties. Trend for those is since several years going North (with no real break of trend in sight). The response of the mainstream parties is pathetic (not even to mention all the policy failures (like the Euro itself)).
Problem is that very likely 3 possibly 5 Northern countries can blow up the EZ and several in the South as well if things are not properly managed (and nothing is so far) so we can probably assume that if Italy or Spain goes the thing blows up.
Similar with the other Southern ones especially Greece no P&L/budget costs have been accounted for the Greek rescue (except some very marginal amounts). If you get a huge write off the party will start up North. Budget items requiring cuts somewhere else (national goodies). Then you get the party started.

So imho one can savely presume that there is a bubble. A bubble doesnot need to burst. Sometimes growth catches up in a way that real stuff is put in place of the hot air that gets out (keeping the price in tact).
But nevertheless there is a bubble (and the risk attached to that), simply would mean that the consequences for a large part do not surface.
However as the article also states does anybody really thinks that growth will really catch up in say Spain (simply way too much much cheaper competition).

Rollo said...

Here is a fairy tale. Some poor countries, well used to high inflation, low growth and very high borrowing costs, join the Euro. They are now safe to borrow enormously at low cost. And they do. They are perfect sub-prime borrowers; they live beyond their means and bang! they get their come-uppance and have to be saved. In chapter 2, they are now safe again to borrow freely and cheaply and enormously. Watch this space for the surprise denouement.

Jesper said...

@Rik,

read up on valuation of bonds, then comment. Specifically the difference between bonds in hold to maturity and and bonds in trading account.