It’s tempting to take a glass-half-full reading of this week’ selloff in euro-zone bonds. After all, they have, for once, moved cohesively in the same direction.
At the height of the euro crisis, German bunds used to rally at the first sign of nerves in Spanish, Irish or Italian bond markets, a safe-haven response that emphasized the stark divisions between “peripheral” and “core” countries and which highlighted the risk of the monetary union’s eventual breakup.
But now, as renewed flight from higher yielding bond markets drives the 10-year Spanish bond yield up over 5%, German bund yields are also spiking, with the 10-year yield adding more than two thirds of a percentage point since early May.
It seems as if investors are saying that the various measures to strengthen the euro zone have forced its members into the same boat and that the unity of their group is now beyond question.
But the presence of a glass-half-full view always points to an alternative, half-empty interpretation. In this case, the pessimists hold that the revival of positive market correlations reflects an unhealthy “balkanization” of the euro zone’s financial system.
As the crisis progressed, German and French banks that had previously bet heavily on higher yielding countries such as Spain and Italy pulled out of those markets and repatriated their funds.
Meanwhile, the European Central Bank set up long-term refinancing operations, or LTROs, via its member national central banks, which led the commercial banks of Spain and Italy to fill the breach and take on bigger proportions of their governments’ debts.
The only reason bond markets are now correlated, these people say, is because banks in both the core and the peripheral countries are separately pulling out of their respective domestic markets in response to the global pressures set off by the Federal Reserve’s threat to wind down its monetary stimulus.
From this perspective, the correlation of euro-zone bond markets is a sign of division, not unity.
The optimists will counter that, although rising yields in Spain and Italy increase the effective cost of borrowing for these countries’ governments and companies, it won’t get out of hand because of ECB President Mario Draghi’s “whatever it takes” pledge to buy sovereign debt in the event of a meltdown.
The fact that the euro itself is holding up reasonably well suggests that this powerful “outright monetary transactions” program from the ECB is expected to work — or so argue the glass-half-fullers.
Of course, the pessimists will have another retort, and that is that balkanization has left Spain’s and Italy’s domestic banks holding an unbearably larger burden of the losses from falling bond prices.
And given the crisis they’ve just come through, they’re not in good shape to absorb any big hits right now. Spain’s banks, torn asunder by a brutal housing crisis, have been partly recapitalized as the government drew down 41.3 billion euros from a 100-billion-euro credit line from the EU.
And as financial conditions deteriorate, it may have to tap more of it. But the euro-zone’s finance ministers decided last week that member countries could not transfer prior loans granted for bank bailouts over to the European Stability Mechanism, the new common bailout fund.
And that could make Spain balk at taking on more debt. In its hesitation, Spanish banks’ balance sheets could come under attack.
The “home bias” in banks’ holdings of Spanish and Italian debt means that that “an increase in the borrowing costs or difficulty to roll over the paper … has the potential to trigger again the downward spiral between bank and sovereign credit risks,” says Viral Acharya, a professor of economics at New York University.
We tend to think of the euro-zone crisis as a sovereign-debt crisis. But at its heart, it was a banking crisis — or at least a result of the unholy, systemically risky relationship between sovereigns and banks. That problem has not been fixed.
marketwatch.com
At the height of the euro crisis, German bunds used to rally at the first sign of nerves in Spanish, Irish or Italian bond markets, a safe-haven response that emphasized the stark divisions between “peripheral” and “core” countries and which highlighted the risk of the monetary union’s eventual breakup.
But now, as renewed flight from higher yielding bond markets drives the 10-year Spanish bond yield up over 5%, German bund yields are also spiking, with the 10-year yield adding more than two thirds of a percentage point since early May.
It seems as if investors are saying that the various measures to strengthen the euro zone have forced its members into the same boat and that the unity of their group is now beyond question.
But the presence of a glass-half-full view always points to an alternative, half-empty interpretation. In this case, the pessimists hold that the revival of positive market correlations reflects an unhealthy “balkanization” of the euro zone’s financial system.
As the crisis progressed, German and French banks that had previously bet heavily on higher yielding countries such as Spain and Italy pulled out of those markets and repatriated their funds.
Meanwhile, the European Central Bank set up long-term refinancing operations, or LTROs, via its member national central banks, which led the commercial banks of Spain and Italy to fill the breach and take on bigger proportions of their governments’ debts.
The only reason bond markets are now correlated, these people say, is because banks in both the core and the peripheral countries are separately pulling out of their respective domestic markets in response to the global pressures set off by the Federal Reserve’s threat to wind down its monetary stimulus.
From this perspective, the correlation of euro-zone bond markets is a sign of division, not unity.
The optimists will counter that, although rising yields in Spain and Italy increase the effective cost of borrowing for these countries’ governments and companies, it won’t get out of hand because of ECB President Mario Draghi’s “whatever it takes” pledge to buy sovereign debt in the event of a meltdown.
The fact that the euro itself is holding up reasonably well suggests that this powerful “outright monetary transactions” program from the ECB is expected to work — or so argue the glass-half-fullers.
Of course, the pessimists will have another retort, and that is that balkanization has left Spain’s and Italy’s domestic banks holding an unbearably larger burden of the losses from falling bond prices.
And given the crisis they’ve just come through, they’re not in good shape to absorb any big hits right now. Spain’s banks, torn asunder by a brutal housing crisis, have been partly recapitalized as the government drew down 41.3 billion euros from a 100-billion-euro credit line from the EU.
And as financial conditions deteriorate, it may have to tap more of it. But the euro-zone’s finance ministers decided last week that member countries could not transfer prior loans granted for bank bailouts over to the European Stability Mechanism, the new common bailout fund.
And that could make Spain balk at taking on more debt. In its hesitation, Spanish banks’ balance sheets could come under attack.
The “home bias” in banks’ holdings of Spanish and Italian debt means that that “an increase in the borrowing costs or difficulty to roll over the paper … has the potential to trigger again the downward spiral between bank and sovereign credit risks,” says Viral Acharya, a professor of economics at New York University.
We tend to think of the euro-zone crisis as a sovereign-debt crisis. But at its heart, it was a banking crisis — or at least a result of the unholy, systemically risky relationship between sovereigns and banks. That problem has not been fixed.
marketwatch.com
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