The rally in Eurozone government bonds has been dramatic over the last two years and has maintained its momentum into this year. German bund yields have dropped to just 1.3 percent (from 1.9 percent last September) while yields in the peripheral Eurozone states (Greece, Spain, Portugal and Ireland) have compressed markedly. Greek 10-year yields are now below 6 percent, having been 10 percent last September, Portuguese yields have halved from 7 percent to 3.5 percent and Spanish and Irish yields have fallen from 4-4.5 percent to 2.5-2.7 percent.
So Spanish and Irish bonds, seen at risk of default just a few years ago, are now yielding the same or even slightly less than US Treasuries. Why has this happened and is it sustainable?
In our view the rally reflects in large part a dramatic reassessment of credit risk. One factor behind this has been improving fundamentals in the peripherals. Budget and current account deficits have generally come down.
In addition, there has been a general compression of risk spreads across assets. This is partly linked to the decision by the US Fed to embark on a third round of quantitative easing (QE) in September 2012 and also to subsequent dovish guidance on interest rates.
But the biggest impact in our view has come from a change in the way that investors view sovereign credit risk in the Eurozone. This may be traced to the now-celebrated ‘whatever it takes’ speech by ECB President Draghi in July 2012. In this speech, Draghi made clear that the ECB was not willing to tolerate any risk to the integrity of the Eurozone currency from dysfunctional bond markets in the peripherals. If necessary, the ECB would step in to backstop bond markets.
Moreover, developments in inflation and growth in the Eurozone have also supported lower bond yields – and possibly further compression still. Inflation has been hovering around 0.5 percent for several months now, and with economic growth also subdued the ECB has made it clear that short-term interest rates will remain very low for an ‘extended’ period.
Against this background, government yields in the ‘core’ countries are likely to remain very low and even drop further. The possibility of a Japanese-style world where short-term interest rates are permanently stuck near zero is coming into view. This will tend to reduce longer-term yields not only by reducing the expected future path of short-term rates but also by reducing the term spread in longer-term rates.
In the peripherals, meanwhile, inflation is even lower than at the Eurozone-wide level. Indeed, Greece and Portugal are experiencing falling prices.
If investors start to believe that current low inflation rates in the peripherals are here to stay, then these real yields will look very attractive and may well be forced downwards.
A deflationary environment, permanently very low short-term rates and a perceived absence of default risk could add up to a Japanese-style future for Eurozone government bond markets.
Arguably, Eurozone bond markets are already shifting in the Japanese direction, and perhaps at a faster pace than occurred in Japan. German 10-year bund yields at 1.3 percent are already at the levels seen in Japan in the late 1990s. But bund yields could yet drop further, compressing below 1 percent, if the Japanese pattern continues to be followed.
For the peripherals, a Japanese-style future would also imply further yield compression. If core yields held at around 1 percent, and if credit spreads over Germany were to revert to end-2008 levels, this would imply yields around 3 percent for Greece, 2 percent for Spain and Portugal and 2.5 percent for Ireland and Italy.
There are also reasons for caution concerning the prospect of further yield and spread compression in the Eurozone bond markets.
The first of these relates to the overall investment environment. The period since Q3 2012 has been a buoyant one for risk assets helped by Federal Reserve policy, but the Fed is now tapering asset purchases and will start raising rates next year. This may lead to a shift away from risky assets, pushing Eurozone peripheral bond spreads up.
Another objection to the idea that Eurozone peripheral yields and spreads could decline further is that it is simply wrong to assume that credit risk has become negligible in Eurozone bond markets. The example of Greece, and to a lesser extent Cyprus, shows that the Eurozone authorities are prepared to inflict heavy losses on investors if they see fit.
Politics: A final source of risk is political developments. Arguably, the case for further declines in government bond yields in the peripherals rests to a great extent on a political calculation. The bullish political case argues that the Eurozone authorities have removed default risk from the Eurozone bond markets so that troubled countries will get serial bail-outs if necessary.
The bearish political case would point to two risks: that the Eurozone creditor countries tire of bail-outs and once again impose losses on private sector investors, or that debtor countries tire of the austerity policies imposed as a condition of external financial support and decide upon a unilateral restructuring of debts.
Currently, neither of these bearish risks appears very elevated. The Greek default was a chastening experience for the Eurozone governments, causing a degree of contagion that threatened to split the Eurozone apart. We doubt there is much appetite currently to risk a repetition of this – though ‘creditor fatigue’ in the longer-run could re-emerge.
The writer is senior economist at Oxford Economics.
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