The eurozone is the frozenzone

The eurozone is the frozenzone

19 Jun 2014

The yields of bonds issued by government are broadly influenced by three factors: the performance of the underlying economy; the outlook for the currency in which the bonds are denominated; and the probability of default.

Eurozone government bonds have demonstrated all three factors at work since the financial crisis hit in 2008.

The story can be traced by the changing yields offered by (for example) Italian 10 year government bonds since 2008. In the first half of 2008, yields rose as the market worried that governments would have to issue more debt to bail out a few troubled financial institutions. This was widely expected to be inflationary (bad news for bonds). By mid-2008, worries began to be directed towards the probability that the crisis was going to cause recession and that interest rates were heading down. For two years, Italian bond yields fell. Then the story changed again. The possibility that Italy (and a number of other Eurozone countries) might default caused near panic.


Finally, in late 2011, the ECB began to convince investors that a solution would somehow be found. The second blip in yields in the summer of 2012 coincided with much wild talk of the break-up of the euro causing some panicky types to worry that Italy et al would honour their debt in a new made-up currency that they could “print” themselves. This was an irrational fear, not least because much of the German and French banking system was a huge holder of such debt and would have been effectively destroyed.

Through the rest of 2012 and 2013, Italian government bond yields normalised, offering a consensus view that the economy was poor, inflation low and the government unreliable but unlikely actually to default.

In 2014, something quite different has happened. Yields on Eurozone bonds have started to deliver a single rather shocking message – low economic growth and low inflation are here to stay for years and years. Assuming that an investor is happy to disregard the risk that the Italian government will default, we must contemplate the fact that he apparently believes that a 2.6% return on Italian assets is enough to justify a ten year investment.

As the next chart shows, this has been a eurozone phenomenon, with Portugal and Ireland in particular delivering sensational returns to those brave enough to invest two years ago.


It seems to me that the market’s perception of the performance of the underlying eurozone economy is now driving bond yields to unimagined lows. You could argue that monetary and currency union have been highly effective, though perhaps with unintended consequences.

As we know, currency union appeared to bestow German interest rates and, by extension, German financial stability on a number of countries that were unaccustomed to either. Governments and populations borrowed enthusiastically and irresponsible banks funded them to the point of mutually assured destruction. It is probable that, in 2014, we are only a part of the way (perhaps less than halfway) to undoing this damage.

This seems reminiscent of what happened to Japan in the 1990s (and what might happen to China in the future). Once the banking system cannot value its loan portfolio without advertising its own insolvency, the state has two choices. The first is to knock its banks down and simultaneously build them up again by guaranteeing their liabilities and purchasing some of their toxic assets. This is roughly what was done in the US and the UK. This results in short term pain (aka “austerity”) and requires a certain amount of resolve among central bankers and – a rarer quality – bravery on the part of politicians.

The second option is the application of endless layers of financial fudge. This was the choice made by Japan in the 1990s and by Europe in 2009. Japan was said to have suffered a “lost decade”. Some people upgraded this to two lost decades. An economist named Richard Koo has characterised the Japanese plight as a “balance sheet recession”. Very simply, if it is widely thought that many banks and other corporations have hidden losses, solvent companies will decline to invest but will continue to reinforce their own balance sheets against the day of the next crash. This will in turn restrain wages and consumer confidence. To some extent you can see this happening in the UK today but, compared to Europe, the UK is in robust health.

Here is the GDP growth of the last eight quarters for the UK and the EA 18 (the eurozone countries).


Here is the growing premium of gilt yields over German Bund yields.


It can hardly be said that the eurozone has recovered at all. In Q1 2014, France had zero growth and the Netherlands, Italy and Portugal were all negative. Inflation for the eurozone fell 0.1% in May, month on month and rose by just 0.5% year on year.

Monetary union? Be careful what you wish for.

With such low returns available, investors are likely to maintain their appetite for risk, in theory continuing to support equity markets and all kinds of financial assets. Those people who still think that the stock market is supposed to reflect GDP will continue to be baffled, stressed and frightened. But experience and reason tell us that fear is good medicine for stock markets. Complacency is poison. I am struggling to find signs of dangerous complacency. Or does that mean that I am exhibiting them myself?


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