In 2011, financial markets were dominated by news surrounding the debt problems in the Western world, and markets saw record levels of volatility. The issues in Europe as well as in the United States are equally alarming, and the coming months will show us whether policymakers are able to stabilize the situation.
The structure of the problem might be very similar; however, Europeans and Americans deal with it differently. While Europe seems to be engaging in a more active discussion about how to deal with its situation, the United States has not made a lot of progress in getting its house in order.
The risk Europe faces is that it might cut spending so much that the austerity measures cause the economy to contract significantly. The measures taken might have far-reaching consequences, and the contracting economy might eventually cause actual government income to decrease. Lower spending and lower income would result in a stagnant, high deficit.
On the other hand, the United States is trying to be less aggressive. While cutting spending is important, officials are trying to do so in a bit more moderate fashion than Europe.
It has yet to be seen which strategy will work better, but it seems to be obvious that inflation eventually becomes part of the solution. Ultimately, inflation could play the greatest role in solving the problem, if the size of the existing debt were devalued by an increase in inflation. In that sense, a devaluation of money would cause inflation. Savers and creditors would be hurt the most, while people with debt would see their situations improve. This summarizes the main structure of the problem as we have outlined in previous reports.
It should be obvious to everyone that the global economy and financial markets will continue to be heavily influenced by the way the Western world deals with its debt problems. Therefore, I would like today to look at the recent developments, especially in Europe, in order to judge the situation and whether an improvement can be expected soon.
Given the recent downgrade of the Eurozone countries by the rating agency Standard & Poor’s, one might think that the situation has worsened since the start of the year. However, I think there is reason to believe that the situation might improve in coming months. A number of European countries have tested the market since the start of the year by selling short- and long-term bonds to investors. These bond auctions have been quite successful, not only with regard to the actual demand for these bonds but also in terms of the yield investors demanded.
Yield spreads for Italian and Spanish debt have fallen significantly from the levels seen in the last quarter of 2011. For example, Italy is paying a yield of 4.83 percent for bonds maturing in 2014. That’s almost 1 percent lower than what it had to pay in December. For bonds maturing in 2018, the yield was 5.75 percent – also down significantly from 2011 levels. Also, Spain had a number of successful bond auctions.
Another sign that the “fear premium” for European sovereign paper is falling is shown by the results of the German bond auction last week. The country paid a yield of 0.9 percent for five-year bonds, setting a new record low. Demand for European government paper has also improved, with demand exceeding supply by a wide margin. Germany’s auction, for example, attracted almost twice the amount in bids than what it had to offer.
While some people think that the recent slide in yields was caused by some kind of “behind the scenes” central bank intervention, this argument fails to explain the broad-based slide in government yields. In my view, this development reflects a general move to a more “normal” market environment again.
Last year, fear and panic resulted in a hysterical market environment, sending yields of European governments bonds to record levels. Just two or three years ago, we had the exact opposite extreme when Italian and Spanish yields were almost as low as German yields, therefore reflecting little to no risk premium. Looking at the economic fundamentals, it should be clear that this was also a general mispricing of credit risk. A reversion to the mean had to happen at some point.
We have now witnessed an overreaction to the upside; and, once again, we expect yield spreads to move back to fair value. Fair value in this case means that Italy and Spain have to pay higher yields to attract buyers like they had to do historically.
While the start to the New Year has certainly been encouraging, it remains to be seen whether the situation will improve further. Italy and Spain face a number of tests in coming weeks, as they are going to renew a lot of debt for longer maturities. A continued trend toward a further normalization of yields would be very encouraging, but this is possible only if the European Union finds a solution for Greece’s financial woes.
Despite the relatively small size of the country, it is important in the overall context. There is real risk that Greece will default on its debt obligation should it not be able to negotiate a debt restructuring with its creditors (banks, hedge funds, etc.). While these lenders seem to be willing to accept a cut of up to 50 percent of their positions, they do not seem to agree on the rate/yield at which the debt is being rolled over. Should Greece find an agreement with its lenders on how to restructure the existing debt, then I think it is possible that the European debt situation can be managed. Of course, it is not going to be enough just to cut spending; troubled countries need to work out plans how to make their economies more competitive and, therefore, stimulate growth in the long run.
The debt problems in the Western world are far from being solved. Actually, the Western world might not be able to solve these problems entirely, at least not in the next decade. For now, the key is to make one step after another and make policy changes and structural reforms that make sense. The pressure from financial markets is finally forcing change, and governments are measured by their ability to balance their budgets. This will be a key issue as a large number of major governments face election tests this year.