European bond buyers: often wrong, never in doubt

November 14, 2011

By Edward Hadas
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Legend has it that a senior Swedish official, after a trip to New York in the midst of the Nordic country’s financial crisis two decades ago, said: “We shall never again trust our economy’s future to the whims of 25-year old men with too much testosterone.”

Many euro zone politicians and central bankers must feel the same way. Bond traders are a dangerously fickle lot. For years, traders hardly worried about fiscal strength inside the euro zone. From 2000 through 2007, the average spread between yields on 10-year bonds of Greece and Germany was a miniscule 35 basis points. For Italy, it was 24 basis points. The recession of 2009 altered the traders’ mood, but not by much. Spreads that year averaged 189 basis points for Greece and 102 for Italy.

Throughout the last decade, the European Central Bank expressed concerns about the market’s almost blind optimism, but nothing substantial was done to shock the traders into alertness. Now, everything has changed. The bond market has become hyper-attentive to economic flaws and hyper-demanding of reform (inside the euro zone, though not for the United States or UK).

The reformist zeal is welcomed by almost everyone – except some insiders in the economic establishments of Italy and Greece. Many outsiders had always hoped the discipline of monetary union would lead to substantial reforms, but were disappointed by investors’ complacency.

Still, there can be too much of a good thing, whether it is confidence or fear. Some investors seem to have decided to stay away from Italian debt until GDP starts growing, the government runs a surplus and the European Central Bank declares it will limit their losses. Even then, they will probably demand spreads ten times wider than in the pre-crisis days, when the issuing governments cared much less about deficits or transparency.

Warren Buffett once said of Mr Market that “the poor fellow has incurable emotional problems.” The new prime ministers of Greece and Italy, and the new president of the ECB, would dearly like to deal with more rational counterparties. The desire is legitimate, but comes late in the day. As a result of inadequate anticipation, politicians and the ECB now must try to solve more complex problems.

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Is “efficient markets hypothesis” still being taught?

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