The latest political news flowing out of Europe’s financial sinkholes ought to help calm frazzled markets.
Italy’s new crisis manager, Yale alumnus Mario Monti, prevailed in his first key confidence vote, paving the way for the promised harsh reforms that European allies and institutional investors have been demanding. Across the Ionian Sea, Greek technocrat-in-chief Lucas Papademos, another U.S.-schooled economist, secured enough votes for a budget whose primary purpose is to keep the bailout cash coming. And in Spain, voters handed over the government reins to a conservative party committed to further austerity.
But it’s a case of far too little too late for the sovereign bond world, which remains in a sour mood. True, high yields on Italian and Spanish debt narrowed somewhat by the end of the week and the euro stopped a week-long slide. But that occurred only after more bond buying by the European Central Bank, whose intervention in the marketplace remains as limited as it is reluctant.
“There’s absolutely nothing the peripheral issuers can do on their own to make this go away. Absolutely nothing,” says Peter Schaffrik, head of European rates strategy with Royal Bank of Canada in London.
That’s partly because of the way the market is structured, but more because of the growing conviction that the feuding Europeans aren’t going to be able to dig their way out of this mess any time soon. Germany fiercely opposes the most obvious remedies, which include turning the central bank into a true lender of last resort and issuing euro-wide bonds backed by the strongest members of the currency club.
“It’s the old saying: Credibility is easy to destroy and very difficult to rebuild,” Mr. Schaffrik said during a brief visit to Toronto to update clients on the latest developments in the war zone.
One reason it’s so hard to reverse the market’s direction has to do with why investors buy government bonds in the first place. The obvious attraction is their relative safety, which throws Greece out of the equation and makes it hard to justify holding the bonds of Portugal or Ireland, the other euro-zone members voted most likely to default in the months ahead.
But the greatest appeal of sovereign bonds lies in the fact major institutions from central banks to big pension funds, banks, life insurers and hedge funds can park vast sums that would sink smaller markets.
“It’s usually a [deep]market where they can deal in size,” Mr. Schaffrik says. “They don’t invest a couple of million. They invest a couple of billion and they need a market that can absorb that.”
Those investors also need an extremely liquid market where they can move in and out of positions relatively easily. But the euro zone’s crisis of credibility means a lot of what traditionally has made its government market so attractive “has fallen by the wayside. Liquidity has thinned out. It is hardly present any more. Volatility is enormous. So if you’re a dealer in this market, you can’t hold any position. You can’t warehouse any risk.”
Perhaps worst of all, credit risk has been introduced in a market once considered essentially risk-free.
With all that at play, it makes sense that investors would steer clear of Italian debt even if they agree that the country remains solvent. “A lot of people are saying: ‘I can’t buy it. I can’t increase my positions because I might never get out again. Or I might not be able to hold my position because my risk limits are broken,’ ” Mr. Schaffrik says.
So “the whole market structure is breaking down. A lot of people who would otherwise be involved have to leave, quite rationally.”
The only way to arrest this particular capital flight is for the stubbornly conservative ECB to change stripes and intervene aggressively in the bond market. Simply signalling that it is prepared to buy unlimited quantities of the affected assets could be enough to put a cap on rates and restore a measure of investor confidence.
The ECB could theoretically do so without the support of Germany, which fears a more activist central bank would trigger a wave of inflation. But without Germany’s wholehearted backing, the rest of the prescription preferred by most bond and currency specialists can’t be filled.
“They need to pledge more aid. They need to show that they are really doing something to keep the euro together,” Mr. Schaffrik says of his home country. “That’s not what they’re doing at the moment. Quite the contrary.”
Indeed, Chancellor Angela Merkel’s own party has voted to introduce euro exit strategies for those countries that want out. “That’s clearly not conducive to restoring trust in the European Monetary Union.”
And Berlin remains virulently opposed to issuing eurobonds or some other form of pan-euro bond guarantees, out of fear the fiscally challenged members of the club will return to their irresponsible ways if their borrowing costs fall sharply.
Mr. Schaffrik and other analysts argue that a safe financing channel can be created for the weaker countries without stripping away incentives to behave. “So they should not be so dogmatic about this. Quite frankly, I think we will get there eventually. The question for me is how quickly.”
In the meantime, Italy, Spain and the other members of the euro zone’s underclass can expect their harsh treatment at the hands of the bond vigilantes to continue.