The Wilder View

EA Spreads: Why Should the Trend Change?

They changed the title; but originally the NY Times reported “Euro Zone Agrees to Reinforce Maastricht Rules“.  That’s exactly what EA policy makers agreed to last week – not much to bring home.

The real shift in policy came from the ECB. Ambrose Evans-Pritchard highlights the ECB’s actions as ensuring some sort of bank profitability, while at the same time defining the buyer of EA sovereign bonds. The banks will access funding from the ECB for up to 3 years at a very low and variable rate – currently the policy rate is 1% – and earn a higher return on their holdings of government debt (This morning, Italian 2-yr debt is trading at 6.05% – not bad). The banks will be ‘encouraged’ to buy government debt, thereby ensuring a funding source for the sovereigns. But this is not a business model, neither for the banks nor for the sovereigns.

Europe is headed toward recession – in fact, it’s probably already contracting – and EU policy makers agreed to explicitly enforce contractionary policy. Kevin O’Rourke calls it a Summit of Death, while Paul Krugman argues the impossibility of the grand internal devaluation experiment. I call it economic oppression coupled with zombie bank deleveraging – it is absolutely not in Spain’s best interest to be pushing sharp fiscal contraction while the private sector is itself deleveraging.

But alas, they’ve decided to put off the only credible solution, fiscal union, for another time. I suspect that global investors are going to see right through this simple fact. External investors will grow tired of the zombie deleveraging and recession, of which more selling will cheapen bonds further. Regarding bond spreads, why should this Summit lead to any different outcome than the ones before it? It shouldn’t.

Until EA policy makers make a concerted step toward fiscal union, the bond crisis will continue to evolve just as it has at each crossroad in the past. The european sovereign crisis will deteriorate further.

The chart above illustrates the average 10yr spread of the 9 bond markets listed over a like German bund alongside each major announcement date (see table below) through December 9. The trend has been up while volatile. Furthermore, no announcement to date has successfully stemmed the upward bias in bond spreads. EA policy makers consistently avoid the only truly credible answer: fiscal union.


The table below lists the dates and associated ECB/EU announcements used in the chart above.

2 Responses to “EA Spreads: Why Should the Trend Change?”

Patrick_VBDecember 13th, 2011 at 12:04 pm

Hello Rebecca,
You state that the ECB's two new 36-months LTRO (long term refinancing operations) are at variable rate. In fact, they will be conducted as fixed rate, full allotment tenders, just like the current MRO (main refinancing operations).
And a question: your average Rate Spread, do you compute it weighting the individual country rates (e.g., by GDP, or outstanding debt) ?

rwilder3December 13th, 2011 at 12:49 pm

Hi Patrick_VB,

Thank you for coming by! I agree, the rate is fixed. However, it is variable in the sense that the fixed rate is determined by the minimum bid rates in the MROs over the life of the loan. So if the ECB hikes or lowers its refi rate over the next 3 years, that will be reflected in the interest rate in an LTRO operation today. There remains some interest rate uncertainty.

For the spread, I use a simple average rather than a weighted average. I started with a weighted average, but wanted to better pick up the movement in the smaller country spreads that were driving the announcements. Stress in the Italian bond market, for example, wasn't driving the announced measures back in the middle of 2011 – however, it would reduce the spread volatility if I used a weighted average. Thus, I use a simple mean.

Thanks, Rebecca

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