Weekly Bond Yield developments in the Euro Area (W30.2011): Decaying Core & Differentiated Periphery

This article made me wonder what might be going on in the Eurozone, and I figured I might as well have a look around and compile this week’s development. Then I figured I might as well begin a new series of posts very unoriginally titled “Weekly Bond Yield developments in the Euro Area (‘week’.’year’)”. So from now onwards, if I have the time, on Fridays or on Saturdays I’ll try to post a figure like the one below.

So what has been going on in the European sovereign debt markets this week?

You almost don’t need to open the images. The order of the columns is:

  1. Portugal
  2. Ireland
  3. Greece
  4. Spain
  5. Italy
  6. Begium
  7. France
  8. and Germany

The rows are the yields on 2, 5 and 10 year sovereign bonds as provided by Bloomberg (Check data section for individual links).

As you can see, Portugal’s yields did fare well this week, as did Ireland’s. This is most likely due to credible governmental and political commitments to lowering the deficits and reforming their countries as well as to a decrease in their EFSF interest rates. Good for them for doing so and good for the markets for picking it up. Now whether they’ll be able to reach a sustainable debt path is altogether a different issue. Particularly in light of the likely negative effects of governmental austerity. Then again there might be some hope that Alesina is right and that the structural reforms will counter balance the austerity in Portugal and that Irish banks might do some trick, although without devaluating the Euro, I wouldn’t count on it.

Next there’s Greece. The increase in the yields is simple enough to understand. There’s a very big chance that the country will default on its debts. Rising yields are pricing the risk of default. Alternatively they may also be pricing the fact that the private sector will not participate in the bail in, if it is too expensive. The private sector bail in was a mess from the beginning. Using proposals from the IIF is a huge conflict of interest. If the point is to help Greece and get private sector involvement (PSI) then you don’t make it voluntary and you don’t ask them to draft the options. There should have been one coercive bail in with on par rescheduling and that should have been that. If you can’t do a restructuring right, don’t do it at all. I hope my warning about the potential mess of a confusing restructure doesn’t become true.

Moving on to Spain, Italy and Belgium is the really interesting part. Spain and Italy are unsurprisingly in the same yield bracket ( 4,2% both for 2Y, 5.3% for Spain and 5.2% for Italy’s 5Y, and 6% for Spain and 5.8% for Italy’s 10Y). Belgium is doing better (2.75, 3.67 and 4.34 for 2Y, 5Y and 10Y). Of all of them Belgium is undoubtedly the more “Core” economy. It’s debt burden, at 96.8% of GDP, is high and the lack of government may be confusing to the uninitiated, but certainly there is no imminent risk of collapse. They dealt with their banks some time ago, have one of the largest (gross and net) savings rate in the EU, and their debt is largely domestically owned (Country’s accounts, Pensions as well as an outdated, but still relevant, view on Belgian banks exposure to their sovereign). With a high debt of 119.0% of GDP, markets are probably still concerned over Italy’s political and banking previous problems and the fact that the EFSF is too small. Spain, with its comfortable government debt of 60.3% of GDP, is shaking with electoral anticipation, rating threats and regional unsustainability.

France and Germany fortunately continue to be boringly healthy. The fall is probably due to recovering from uncertainty in the previous week and to investors fleeing American uncertainty.

Interestingly, if all of my readings are correct, there is a deeper insight into the imperfect pricing conducted by the markets. How can markets believe that Spain and Italy are problematic, without thinking this will spillover to the other countries. It clearly makes for a very plain story telling, but it seems a bit desingenuous. If the small size of the EFSF is what’s troubling these countries; yields, then increasing it should bring yields down. However, this means that the liabilities of France and Germany will increase, which in itself should increase their risk of default, bringing their yields up. At the same time, if the markets believe that these countries will not be helped, then it clearly stands that they either believe that there won’t be contagion or they simply have not yet thought about it.

So there are two conclusions. Either markets pricing is imperfect or they are speculating. Both options should make freshwater economists a bit uncomfortable…

Either way, whatever the reason is, it seems we are set for more trouble with finance ministers being forced to do something again. But what? I’ll try to say something quickly in the next post.

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