2nd May 2013
The cut in rates by the European Central bank confirms what many have feared for some time: the global economic recovery is stalling and Europe is suffering more than most. Yet, the European bond markets are painting a very different picture with bond yields at record lows, even for the troubled periphery of Europe. Is this simply a blind refusal to accept the level of risk inherent in the region or is there something more significant at work asks Cherry Reynard.
As the BBC reports, the rate cut confirmed that the ECB is as worried about the economic outlook in the region as many economists. The economic data emerging from the Eurozone is certainly uncomfortable. PMI statistics are weak and weakening. Eurozone economic sentiment hit a 4-month low in April, and missed consensus expectations. More worrying was that Germany – for long the engine of Eurozone economic growth – saw one of the biggest drops in the region once again reported on the BBC.
Yet, this weakness has not been reflected in European bond markets, where yields have dropped to historic lows. Most recently, the Italian treasury managed to sell €3bn of 10-year bonds at 3.94%, down from the 4.66% achieved at an auction last month as Ft.com reports. The auction was substantially over-subscribed, suggesting robust demand. Elsewhere, a similar pattern is seen. In Spain, despite its entrenched recession, yields on the 10-year government bond are 4.1%. In Ireland they are just 3.58%.
The disparity has prompted Mike Riddell, manager of the M&G International Bond fund, to raise concerns about an imminent sell-off. This is worrying both for holders of Eurozone debt and for the stability of European economies in general. Beleaguered Eurozone governments can ill-afford a significant rise in the cost of their debt.
Riddell says: “The peripheral rally has continued this year in the face of a significant deterioration in economic data in recent months. Economic fundamentals and valuations are currently moving rapidly in opposite directions.”
He believes that the most vulnerable spot is Spain. “Yes, the ECB can throw liquidity at Spain to keep the debts rolling over, and yes, many other developed countries are arguably in the same boat – Japan’s public debt/GDP ratio is quickly rising towards 300%, which makes Spain’s public debt burden look relatively puny. But as we’ve seen with Greece, sovereign Eurozone debt can and will be restructured when a country is deemed insolvent, and as previously argued in a comment in 2010, this is where Spain appears to be heading.
“Given that Spain’s borrowing costs are higher than its nominal growth rate, it needs to run a primary surplus if it is to stabilise its public debt/GDP ratio. But Spain is actually running a huge budget deficit (averaging 10.2% since 2009), and is therefore running a large primary deficit… Peripheral Eurozone bonds, and Spain’s in particular, look vulnerable to a sell off.”
Why are people still buying? The initial contraction in yields was prompted by Mario Draghi’s ‘we’ll do whatever it takes’ comments last year, which removed a significant tail risk for the Eurozone economies. However, events have moved on since then. At the time, the economic data appeared to be improving and the Eurozone could have expected to be a key beneficiary of the improvement in the US.
But now the situation looks very different. As Andrew Bosomworth, portfolio manager at Pimco, says: “We expect regional growth to be in a range of -0.75% to -1.25% over the next year, with the risk of high unemployment and bail-out fatigue disenfranchising its citizens from the benefits that a monetary union was supposed to achieve. The ECB can buy time, engineer low interest rates and fix the fragmented market for credit. But without its political partners committing to a common destination for the Euro that completes its fiscal architecture, we believe the ECB’s actions alone will not suffice.”
In other words, it would seem that bond investors have not caught up with the new reality. The ECB may be willing to ‘do whatever it takes’, but it cannot save the Eurozone on its own. For that, there needs to be structural reform and there has been relatively little so far.
That said, there may be other structural factors at work in driving the demand for Eurozone bonds – Reuters quotes Vincent Chaigneau, head of rates strategy at Societe Generale in Paris on the potential demand coming from Japanese investors moving out of their domestic market: “We have that ongoing talk about Japanese investors potentially allocating more funds to non-Japanese bonds. All that for now remains supportive for euro zone bonds and with core bond yields being so low we see some appetite for soft core markets like France,” he says.
However, just occasionally, when something looks like a bubble and smells like a bubble, it may just be a bubble. There is evidence elsewhere in the government bond market that the market’s appetite for yield is leading to some reappraisal of risk, For example, Rwanda, with aid making up 38% of government spending, has just issued 10 year bonds at a yield of 6.875%. Reuters said that this, along with the iBonds issuance, is an ‘object lesson in the madness of the bond market.”
This piece on MarketWatch says that the market currently has eerie parallels with the market in 2005 and urges investors to ‘consider their position when the music stops’.
The bond market’s stubborn refusal to accept the new economic reality is worrying. For the time being, investors are still making money, Eurozone governments are still benefiting from low borrowing costs, but it could be very uncomfortable when this particular party ends. The final stages of a bubble are too often characterised by a giddy unwillingness to face up to the real risks.