By Sandra Holdsworth
Before the euro came into existence in 1999, the government debt markets which constitute the bulk of the eurozone all had their own yield curves. As the birth of the euro approached these yield curves ‘converged’ as investors concluded the risk of default on government bonds was negligible and currency risk losses were about to be eliminated.
Therefore there was very little risk investing in the eurozone’s highest yielding government debt markets. For example in 1995, the yield differential between German and Spanish bonds was 367 basis points by the end of 1998 (the eve of the euro) this had collapsed to just 10 basis points.
Much was made of how this was ridiculous, how could yields in higher inflation prone economies like Spain’s ever be convergent with those of Germany? Converge they did however and investors became less concerned over country risks and started looking at the eurozone as a whole to determine what level bond yields should be, with small allowances for individual supply or liquidity considerations.
This homogeneity was encouraged by the collateral rules from the European Central bank, which treated all eurozone government bonds equally with no ‘haircut’ on government debt from countries with lower credit ratings.
Throughout the euro’s early years, this convergence illusion was maintained, opposing it was not a profitable long term strategy and money poured into peripheral bond markets and economies.
Unfortunately the party ended disastrously with the onset of the 2007 financial crisis. This led to a banking crisis which for some led to a government debt crisis, suddenly the unthinkable was a possibility, the construct of the euro was in fact not risk free! Greece got into difficulties and under the Private Sector Initiative policy private sector holders of its debt ‘volunteered’ to have debt holdings restructured, a default in every way but name.
Investors pulled money out of every market where the risks of a repeat performance were perceived to be high. The other bailout countries of Ireland and Portugal followed closely by Italy and Spain and to a lesser extent but dramatically so, out of France and Belgium. The cash headed to safe havens within the Eurozone (Germany, Netherlands, Finland) and out of the eurozone to Swiss Francs, Sterling and US Dollars, until the outlook became clearer.
As countries sought to revive confidence in their ability to finance debt, fiscal policy was tightened, the recession deepened, unemployment rose and inflation fell. Finally in August 2012 the European Central Bank announced an unlimited but conditional policy of supporting the Eurozone peripheral bond markets which was sufficient at least to stop further outflow.
The policy has yet to be activated, but its existence and the confidence the ECB’s president displayed were sufficient to make investors at least think again. As time passed, one by one the countries affected started to export more and by the start of 2014, all were recording either a current account surplus or were moving that way and on the road to recovery.
In 2007 Spain‘s current account deficit was in excess of 9% of GDP, in 2013 it is expected to be a surplus of close to 2% of GDP. Inflation is very low, the Spain of 2014 looks very little like that of 2006, in fact it looks more like Germany than it ever has done, with an export led recovery that’s attracting investors back. Liabilities to the euro-system are reducing, economic growth is rising and the credit outlook is not deteriorating further. All three ratings agencies removed their negative outlook for Spain in Q4 of 2013.
Finally the ECB is committed to ‘normalising’ monetary policy across the eurozone, reducing the differential a company in Spain has to pay to borrow compared to the same company in Germany. To do that the rates governments pay to borrow also have to ‘normalise’, meaning convergence of government bond markets is back on and the ECB is going to do everything to achieve this aim. Again this seems quite ridiculous given the experiences of the last seven years but just maybe it’s time to party like it’s 1999?
Sandra Holdsworth is a fixed income manager at Kames Capital
Comments