Are bond traders pricing in an EMU break-up?

Tony Barber on the FT's Brussels blog urges readers to "watch the yield spread" when it comes to the debt of eurozone governments.

This is an issue Ambrose Evans-Pritchard at the Telegraph has been writing about for a while, and is certainly an interesting proxy for the market's faith in European monetary union. Barber singles out the spread between German and Italian 10-year government bonds: 25.8 basis points one year ago, 69.6 one month ago, 72.3 one week ago and 95.6 today. He summarises the relevance of the issue for EMU:

"[widening bond yield spreads] hint at a degree of uncertainty among investors about the cohesion of the 15-nation eurozone itself - namely, whether Greece and Italy are economically strong and fiscally disciplined enough to share the same currency with Germany over the long term.

This would not be an issue, of course, if the eurozone were like the US and had a central fiscal authority to transfer revenues between flourishing states and states suffering an economic shock. But you cannot have a central fiscal authority without a much greater shift in the direction of European political union than most politicians, taxpayers and voters appear ready to contemplate."

One comment on Barber's blog complains that his argument is focussing too closely on a recent timeframe, citing an enornous yield spread in the mid-90s. But although the yield spread between Italy and Germany by today's standards may have been extremely big at that time, it is also hugely significant what happened to spreads after the launch of the euro.

We had a look back over the data, and as the graph below shows (referring to the differential between the average of non-German eurozone members' bond yields and German bunds), the spread did narrow after the launch of the euro in 1999 (ie. it comes closer to zero, the German baseline), but around midway through last year this trend was sharply reversed, reflected in the upward slope away from zero:




The above graph is a simplification, and will be slightly skewed as a result of the effect of Greece - a relatively small economy with a very high yield on its debt - on the average. But even when we look in detail at the individual national spreads relative to German bunds, this trend is corroborated (apologies for the haziness of our graph - click on it to view in detail):

SOURCE: Eurostat