Why euro zone bond yield ‘convergence’ may be something to fear

April 15, 2013


Are European bond investors looking for love in all the wrong places?

The premium bankers demand to hold various types of euro zone debt over that of Germany has recently come down. In normal circumstances, this might suggest markets are no longer discriminating between the risks associated with different member countries’ bonds. But analysts say the recent convergence is based on a precarious belief of ECB action rather than any real improvement in economic fundamentals.

Spain and Italy still offer a comfortable premium over Germany. But a narrowing in yield spreads that is being driven by a fall in the funding costs of Spain and Italy, rather than by a rise in German yields, gives reason for pause.

According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

The fact there is almost no movement from Germany and a huge movement in peripherals is indicative to us of this convergence for the wrong reason.

If we were getting debt mutualisation and there was a convergence of yields for the right reasons then you would expect there to be a more meeting in the middle than there is.

Spanish and Italian yields have fallen more than 2 percentage points since ECB President Mario Draghi’s promise to protect the euro last year, while German borrowing costs have barely budged over the same period.

If the euro zone crisis had turned a corner and the continent’s economy were on the mend, say analysts, German yields would be rising. Instead, German borrowing costs over ten years are close to their lowest since the ECB pledged to save the euro.

Where German yields go from here “is a judgement call” on whether the “the euro zone crisis is going to revisit us in a more serious way which would effectively call Draghi’s bluff,” according to Marc Ostwald, strategist at Monument Securities.

Recent history also shows the dangers of mispricing risk, analysts say. After the euro was introduced, there was a harmonization in the debt yields of different euro zone members even though they still had quite diverse economic and fiscal fundamentals.

According to Alan McQuaid, chief economist at Merrion Stockbrokers:

I still think the yields are too close together (compared) to what they should be… there is an inevitability about this that you are going to go back to square one and we will have another blow-out at some stage.

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Underpricing risk is what QE (FED/BOJ) is all about. Eventually, once all of the “safer” assets are gone, the search for yield leads all of this hot money to much more dangerous assets. This is how bubbles are formed, and the foundations for their popping are laid.

Central banks are great at forcing down risk premia, while doing nearly nothing to mitigate the underlying risks.

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