The European debt market is cracking, again. It wasn't supposed to. The euro zone economy is on the mend and inflation is coming back. Unemployment is dropping. The region, for all its faults and mismanagement, is actually outperforming the U.S. economy.
So how can sovereign-bond yields be rising in France and Italy, the region's second- and third-largest economies, and soaring in Greece? Leaving perennial basket case Greece aside – it's bogged down in yet another nasty bailout problem – the spiking yield driver is political risk, and lots of it, which the European Central Bank's endless stimulus programs can't do anything about.
France is going into a presidential election that could be won by the National Front's Marine Le Pen. She's leading the polls and has a philosophical loathing for everything with "European" or "euro" in its name. She would pull France out of the European Union and ditch the euro.
Italy also faces political risk. Beppe Grillo's Five Star Movement, the populist, anti-establishment and euro-skeptic party that is already the main opposition party, could win the next election – it's polling on par with the ruling centre-left Democratic Party. If elected, Five Star vows to hold a referendum on the euro.
Not to be outdone, Ted Malloch, U.S. President Donald Trump's nominee for U.S. ambassador to the EU, keeps insisting the euro is in deep trouble. "Whether the euro zone survives I think is very much a question that is on the agenda," he said Wednesday on Greek Skai TV. "We have had the exit of the U.K., there are elections in other European countries, so I think it is something that will be determined over the course of the next year, year-and-a half."
Political risk doesn't explain the whole Italian bond-yield story. The country, overseer of the world's third-largest bond market, is facing a debt crisis, one that would have happened even if Italy were blessed with a stable, pro-euro government. Almost every one of the economic and debt numbers in no-growth, debt-soaked Italy is unfit for mention in polite company.
The political risk is reflected in the spreads over benchmark German bonds, those steel-clad Teutonic wonders that are considered Europe's safest debt. On Wednesday afternoon, European time, the yield on French 10-year bonds was 1.06 per cent, putting their "spread," or gap, over equivalent German bonds at 75 basis points (100 basis points equals 1 percentage point). That's the highest spread since November, 2012, when there were still considerable doubts about the euro's survival.
Ten-year Italian bonds were trading at 2.27 per cent, putting their spread over German bonds at 197 basis points, the highest since February, 2014. The spread is also about 60 basis points wider than the Spanish gap over German bonds. Clearly, yields are diverging again, with investors taking the view that Italy is a bigger risk than Spain, which was the champion jobs destroyer during the crisis.
The spread growth between Italian and German bonds is alarming. At the start of 2016, the spread was less than 100 basis points. By the end of 2016, it had climbed to about 165 basis points. The current yield on Italian bonds means the treasury must pay twice as much to attract buyers than it did a year ago, and that has to hurt. The hapless Italian government is sitting on €2.2-trillion ($3.09-trillion Canadian) of debt, for a debt to gross domestic product ratio of 132 per cent, the second-highest in Europe, after Greece.
Italy must refinance about €200-billion of debt this year, and the higher yields means the debt financing costs will rise. Already, Italy forks out about 5.5 per cent of GDP on debt interest. Only the Greek tab is higher. In Germany and France, the figures are 2.3 per cent and 2.5 per cent, respectively, according to a January report by Mediobanca Securities.
Now you know why "Italeave" has joined "Brexit" as the ugliest invented geopolitical term of the era. If Italy's enormous debt is barely sustainable now, it becomes less sustainable as debt costs rise, leading more than a few investors to conclude that Italeave – arrivederci euro – is a clear and present danger.
The Sentix index tells the story. The index measures the one-year probability of Italy leaving the euro zone and is based on institutional investors' assessments. In November, it reached 19 per cent, though January's reading was 15 per cent. While that may not seem high, consider that between 2012 and the first half of last year, a four-year stretch that included the dark depths of the crisis, the index's reading averaged only 2.5 per cent, Mediobanca says.
If any new polls show that Five Star is leaving the Democratic Party behind, the Sentix index will no doubt climb, taking Italian yields, and the spread over German bonds, up with it. French yields and spreads will almost certainly widen too if polls keep putting Ms. Le Pen in the lead.
And let's not forget the ECB's quantitative-easing program, which has been sucking up euro-zone financial assets, mostly government bonds, at an enormous rate – €80-billion a month. Those purchases are to fall to €60-billion a month starting in April, and they may fall again next year if the inflation target of close to 2 per cent is reached (the flash estimate in January was 1.8 per cent). QE's end could send bond yields even higher. Add in the threat from the rising euro-skeptic parties and it's not a stretch to conclude that the European debt crisis is ready for a comeback.
Eric Reguly