It has been a long time since European Bond Rates have been so low. In fact, in some cases one has to go back beyond the Napoleonic Wars in the early nineteenth century to find longer-term interest rates so low. That is a long time.
The lowest of the yields in Europe belong to the Germans. The 10-year German Bund closed at 1.41 percent on Tuesday evening and has been trading to yield somewhere in the range of 1.35 percent and 1.45 percent over the past several weeks.
Everything else in Europe is looked at, more or less, relative to the yield on the German securities.
Right now, Germany is economically the strongest of the eurozone countries and is fiscally conservative and vocally so.
The 10-year German Bund began the year trading around the 1.90 percent level. The yield began to decline in the middle of January as it became more and more apparent that the economic growth rate in the eurozone was weakening and that the dis-inflation of prices was going to continue.
By the start of February, yield had dropped to the 1.65 percent level. For the next couple of months the 10-year security traded in the 1.50 percent to 1.60 percent range. After the middle of May, the yield fell into the 1.30 percent to 1.40 percent range.
What seems to have happened this year is that the eurozone economies were reported to be growing less rapidly than had been expected and the rate of inflation continued to drop, raising more and more fear that the continent of Europe was going to actually experience a period of deflation!
The inflation figures for May came out earlier this week and the year-over-year rate of growth of eurozone prices fell to 0.5 percent. This is down from 0.7 percent in April. Some forecasts put expectations for the June rate as low as 0.4 percent. Hence the fear that deflation might be just around the corner.
This has raised questions about the European Central Bank (ECB) and what Mario Draghi, president of the ECB and his colleagues are going to do at their meeting today, June 5, 2014. The betting is that the ECB will lower the interest rate on its policy loans and will reduce the interest rate it pays on funds that banks leave on deposit at the ECB. The interesting thing about the latter interest rate is that to lower it, the ECB must move the rate into negative territory. There is precedence for this as the central banks of Denmark and Sweden, over the past year or so, have taken deposit rates below zero.
The question here relates to whether or not what the ECB is doing will have any impact of eurozone economic growth and what impact, if any, will a change in ECB’s policy stance will have any impact on interest rates on the continent.
On the first point, my answer is that lowering policy interest rates further will do little or nothing to create faster economic growth and prevent deflation. But, this is another story.
In terms of European interest rates I believe that there are two issues here. The first has to do with any short-run adjustment in interest rates. Many analysts believe that investors have already priced in any moves the ECB might make in today’s meeting. Thus, short-run reactions will only result from the ECB moving differently than what it is already expected to do by investors. If the ECB does not reduce policy interest rates in the way that the market expects then bond rates will rise. If the ECB moves more aggressively than expected, these longer-term interest rates will fall.
If economic growth drops further and if dis-inflation turns into deflation, they these longer-term interest rates will probably fall further.
The second factor to look at is the spreads that exist within the bond markets between the yields on German Bunds and yields on other sovereign debt.
Perhaps the most interesting spreads to look at are those relating to several of the countries that have been going through some very tough economic re-structuring: Italy, Spain, and Greece.
At its height during the recent financial problems, the spread between the yield on the 10-year Greek bond and the yield on the 10-year German bund was almost 3,000 basis points. That is, if the yield on the German securities was 2.00 percent, the yield on the Greek bond of similar maturity was about 32.00 percent.
This spread has dropped dramatically over the past couple of years as the European financial crisis wound down. In early September 2012, the spread was only about 2,000 basis points. Early in January 2013, the spread dropped to about 1,000 basis points. By early January 2014 this spread was around 640 basis points and at the current time the spread is a little under 500 basis points.
What a difference! As Greece has gotten some of its reform installed and as the financial markets in Europe have calmed and the “risk averse” money that fled the continent…especially to the United States…returned, not only did the general level of interest rates fall in Europe but interest rate spreads fell to extremely low levels.
This was also the case for Spain. At one point during the crisis, the spread between the yield on Spanish bonds and the yield on the German Bunds topped out around 650No basis points. The path of this spread was pretty much the same as that of Greece. Currently, this spread is a little less than 150 basis points. Spain, even though it is still facing a lot to do in its reform efforts, is sitting pretty good with respect to its longer-term cost of funds, especially when compared with several years ago.
The largest spread that Italian government bonds experienced with German Bunds was about 550 basis points. Now this spread has dropped below 150 basis points, although it is a little higher right now. Italy and Europe are placing a lot of hope in the new, young Italian prime minister Matteo Renzi, hope that he will bring the reforms needed to both Italy…and, by example, to other troubled nations…like Spain and Greece.
Will the new interest rate levels set by the ECB today change these relationships?
The answer I would give is no, any actions that the ECB takes today will not change these relationships. The ECB is looking for ways to keep the monetary spigot open and to maintain sufficient liquidity in European markets. The spreads have come down because governments in the eurozone have responded…although modestly…to the need for reform. The actions of Mr. Draghi and the ECB have raised confidence so that investors are much more comfortable with the position the troubled countries now find themselves in. Thus, investors don’t feel the need to require the more troubled countries to provide them with a greater yield.
I believe that this will continue to be the case as long as Mr. Draghi and the ECB continue to keep the financial markets liquid and as long as they don’t pull any surprises on the market. My belief is that investors still have a lot of concern about the riskiness of the government debt of the troubled countries. And these investors are just jittery enough that a surprise by the ECB…or others…could cause the market to decline…and could cause spreads to grow much wider again.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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